By Emerson Hartzler
The Roth version of the IRA has been around for more than a decade, but is still one of the most misunderstood programs that seniors will encounter. I believe it was Albert Einstein who declared the power of compound interest to be the 8th Wonder of the World. Einstein didn’t live to see the Roth IRA, but I believe he would have declared it Wonder number nine! If an IRA is an important part of your retirement plan, you need to know all about the Roth IRA option.
First, a reminder about the difference between these two IRA options: When you contribute to a “Regular” IRA, the amount contributed is deducted from your gross income, so that only the net amount of income is subject to federal income tax that year. Once the IRA account is established, any earnings that account may have is not subject to income tax, so the power of compound interest is not diminished by taxes. However, when you (or your heirs) withdraw money from the Regular IRA it is considered regular earned income, subject to the tax rate of the person withdrawing the money.
With the Roth IRA option, the amount contributed is NOT deducted from your gross income, so you are essentially “buying” the Roth IRA with dollars after you have paid income tax on your gross earnings. This makes the Roth more “expensive” to “buy” than the regular IRA. As a result, most of us have put our retirement savings into a Regular IRA and called it good.
Now for us seniors who are beginning to withdraw from our IRA’s, the above distinction may seem to be moot – we are no longer contributing, so why should we care what the contribution options are? One word: CONVERSION!
When I moved to my current home in a continuing care retirement community (CCRC), I paid a one-time entry fee, and I also began making monthly fee payments. A percentage of each of those fees in a CCRC like mine is tax deductible as a prepaid medical expense. The first year I paid entry and monthly fees more than $200,000, and that tax deduction was huge, lowering my net income below the level at which I would pay any federal income tax at all! To avoid “wasting” my large tax deduction I needed more income in that year, since the medical deduction cannot be held over for use in subsequent years. Enter the IRA to Roth IRA conversion!
I merely withdrew enough money from my Regular IRA to bring my income to the level where I would pay a minimal amount of federal income tax, converting that money to a Roth IRA account. Why do that? The answer lies in the unique advantage of the Roth IRA.
In the future, I will continue to withdraw money from my Regular IRA and pay income taxes on those “earnings.” But what if I want to withdraw only the earnings from my IRA, leaving the principal for my heirs? The good news is that that principal should earn a return, and none of that is taxed until my heirs decide to withdraw it, and then they will have to pay income tax on those “earnings” at their current tax rate. I have not spoken to anyone recently who believes that future tax rates will be less than they are today, so chances are the tax burden to my heirs will be significant.
However, if I can convert money in my Regular IRA to a Roth IRA, at no real “cost” to me (remember the strategy outlined above to create additional income, taking full advantage of the medical deduction), any future earnings from the Roth IRA will accrue without being taxed, just like the regular IRA. But when my heirs withdraw money from the Roth IRA there is NO tax to be paid! I already satisfied the tax obligation when the money was converted from the Regular IRA to the Roth IRA. After that, neither the earnings of the Roth IRA nor the withdrawal from the Roth IRA is taxed!
A realistic example might bring the power of the Roth conversion into better focus. Let’s say you converted $100,000 in the year you moved to a CCRC, taking full advantage of the medical deduction. Then each year for the next 10 years you converted another $20,000, again taking full advantage of the medical deduction and paying no more taxes than you would have otherwise. You would then be able to pass $300,000, plus earnings, say $500,000, of Roth IRA money to your heirs. Assuming their tax rate is 20 percent, they would pay $100,000 in taxes for withdrawing that money from a Regular IRA, but nothing in taxes for withdrawing from a Roth IRA.
Do I have your attention?
Emerson Hartzler, MBA, is a Lakeview Village resident, and, though he lives in a retirement community, he continues working as a financial advisor for Triune Financial Partners, LLC, at Lighton Plaza, 7300 College Blvd., in Overland Park, Kan. Reach Triune at 913-825-6100.