Monthly Archives: April 2020

An Ode to the Roth IRA

It won’t surprise many to find out that a tax-focused financial planner is fond of the Roth IRA. Below is a brief review of the advantages of a Roth IRA.

Tax Free Growth

Amounts in Roth IRAs grow tax free. Considering many Americans may now live into their 80s, 90s, and beyond, this is a tremendous benefit. 

The only caveat is that in order for all distributions from Roth IRAs to be tax and penalty free, they generally have to be either (a) a return of contributions or of sufficiently aged conversions (see below), or (b) a distribution of earnings made in the Roth IRA (or other amounts in the Roth IRA) at a time when the owner of the account is 59 ½ or older and has owned a Roth IRA for at least five years.

The rules for ordering distributions out of a Roth IRA generally provide that contributions come out first, and then the oldest conversions come out next. This means that in many cases Roth IRA distributions, even those occurring before age 59 ½, are tax and penalty free. 

N.B. Generally speaking, you want to only take a distribution from a Roth IRA before age 59 ½ if it is either (i) a serious emergency or (ii) part of a well crafted, very intentional financial plan. 

Ease of Administration and Withdrawal 

There are many financial institutions that provide Roth IRAs. Investment expenses in low-cost index funds at financial institutions that provide Roth IRAs are approaching zero. Vanguard, Fidelity, and Schwab are among the very good providers of low-cost Roth IRAs (and there are others). 

It is also relatively easy to access money inside a Roth IRA. This makes the Roth IRA a great account to have in an emergency. Of course, it is generally best to leave money inside a Roth IRA to let it grow tax free, but it is good to know that you can access money in a Roth IRA relatively easily if an emergency arises. 

Tax Free Withdrawals of Contributions

This is a great benefit of the Roth IRA. Contributions to a Roth IRA can be withdrawn at any time for any reason tax and penalty free. Further, the first money deemed distributed from a Roth IRA is a contribution. Here is a quick example:

Mark is 35 years old in 2025. He made $6,000 contributions to his Roth IRA in each of 2020, 2021, 2022, 2023, and 2024 (for $30,000 total). In 2025, when his Roth IRA is worth $41,000, Mark withdraws $10,000 from his Roth IRA in 2025. All $10,000 will be deemed to be a return of contributions, and thus entirely tax free and penalty free.

The only exception is a taxpayer favorable exception: a timely withdrawal of an excess contribution (and related earnings) occurs before regular contributions are considered withdrawn. 

N.B. Roth 401(k)s, 403(b)s, and 457s have different distribution rules — most pre-age 59 ½ distributions will take out some taxable earnings.

Tax Free Withdrawals of Sufficiently Aged Converted Amounts 

If you convert an amount into a Roth IRA, you start a five year clock as of January 1st of the year of the conversion. Quick example:

Mike is 35 years old in 2025. Mike converts $10,000 from a traditional IRA to a Roth IRA on July 2, 2025. His five year conversion clock starts January 1, 2025. On January 1, 2030, Mike can withdraw the entire $10,000 he converted in 2025 tax and penalty free. 

This feature of the Roth IRA, the tax free withdrawal of sufficiently aged conversions, is the basis for the Roth Conversion Ladder strategy. Sufficiently aged converted amounts are deemed to come out after contributions are exhausted and before more recent conversions and earnings come out.  

No Required Minimum Distributions

During an account holder’s lifetime, there are no required minimum distributions from a Roth IRA. You can live to 150 and never be required to take money from a Roth IRA.

Creditor Protection

In federal bankruptcy proceedings, Roth IRAs are (as of 2024), protected up to $1,512,350. 

Where there can be differences in liability protection are state general creditor claims (i.e., creditor protection in non-bankruptcy situations). In some states, Roth IRAs receive a level of creditor protection similar to that of ERISA plans. Generally, such protection is absolute against all creditors except for an ex-spouse or the IRS. 

In other states, Roth IRAs receive no or limited creditor protection. In my home state of California, Roth IRAs are only creditor protected up to the amount necessary to provide for you and your dependents in your retirement (as determined by the court). Such protection is valuable but hardly airtight. 

A Sneaky Way to Contribute More to Your Retirement

Yes, in theory everyone should save for retirement based on exacting calculations (i.e., I estimate I need $X in retirement, so based on projections I save $A in traditional accounts and $B in Roth accounts this year). That’s the theory.

In practice, it’s “I maxed out this account and that account” or “I put $C into this account and $D into that account.” There isn’t that much wrong with how we practically save for retirement, as long as we are saving sufficient amounts for retirement.

But not all “maxing out” is created equal. We know this because if Jane has $100,000 in a traditional IRA and Mary has $100,000 in a Roth IRA, who has more wealth? Mary! Unless Jane can always be in a zero percent income tax bracket, Mary has more than Jane, even though they both nominally have $100,000. 

A Great Account to Leave to Heirs

While non-spouse heirs will have to take taxable required distributions from inherited IRAs (in many cases beginning in 2020 they will need to drain the account within 10 years of death), heirs are never taxed on distributions from Roth IRAs. This makes a Roth IRA a great account to leave to your heirs. 

Compare with Other Retirement Accounts

No other retirement account combines ease of administration and withdrawal, low costs, significant tax benefits, creditor protection, and great emergency access the way the Roth IRA does. Most workplace retirement plans have some restrictions on withdrawals. Traditional account withdrawals do not have the tax advantages of a Roth IRA. Distributions from a traditional IRA, even one at a low-cost, easy to use discount brokerage, will trigger ordinary income taxes, and possible penalties, if withdrawn for emergency use. 

Financial Planning Objectives

Personal finance is indeed personal. But I submit the following: pretty much every individual has some desire (and/or need) to not work at some point in his/her lifetime and every individual needs to be prepared for emergencies. Further, these are two very important financial planning objectives for most, if not all, individuals.

If the above is true, then we must ask “which account type best supports the combination of these two pressing financial planning objectives?” It appears to me that the answer is clearly the Roth IRA. 

None of this is to say that a Roth IRA is the only way to plan for retirement and plan for emergencies, but rather, it is to say that, generally speaking, a Roth IRA ought to be a material element in such planning. Other tools, such as other retirement accounts, insurances, investments in taxable accounts, and sufficiently funded emergency funds are likely needed in addition to a Roth IRA. 

Retirement Accounts and Emergencies

Let’s examine how a Roth IRA might help someone facing a very serious emergency. 

Picture Jack, who is 52 years old, and has a full time job. He has $1M in a traditional 401(k) and $10,000 in cash in a taxable account. That’s it. Then picture Chuck, also 52 with a full time job. Chuck has $700,000 in a traditional 401(k), $250,000 in a Roth IRA, and $10,000 in cash.

Who is better situated to deal with an emergency? Far and away the answer is Chuck. 401(k)s are difficult to access in an emergency. First of all, the 401(k) plan might not allow in-service distributions, and it might not allow taking out a loan. 

Even if the 401(k) allows in-service distributions, distributions from 401(k)s are immediately taxable, and often subject to penalties (10% federal, 2.5% in California, for example) if you are under age 59 ½. Loans, while not immediately taxable, can become taxable if not paid back. 

Long story short, a 401(k) may be a tough nut to crack in an emergency.

What about a Roth IRA? In Chuck’s case, he can access his prior Roth IRA contributions and sufficiently aged contributions tax and penalty free at any time for any reason! And his Roth IRA is easy to access, particularly if it is at a low-cost discount brokerage.

When you combine tax-free growth, no requirement to take required minimum distributions during the account holder’s lifetime, and the best emergency access of any tax-advantaged retirement account, it is difficult to see why working adults should not have at least some money in a Roth IRA. 

When a Roth IRA Doesn’t Make Sense

The short answer is: not often! I struggle to come up with profiles of individuals that would not benefit from having some amount in a Roth IRA. 

I can think of two profiles. The first, a rare case, is someone with very large legal liabilities such that all of their wealth would benefit from the creditor protections offered by an ERISA retirement plan (such as a 401(k)) and who needs almost all of their wealth shielded from creditors. 

First, if you have built up 6 figures or more in wealth, having creditors able to claim your entire wealth is relatively rare. Second, in most cases, good insurance coverage, including adequate medical insurance, professional liability insurance (as applicable), home and automobile insurance, and personal umbrella liability insurance, should protect the vast majority of people such that they could withstand any liability exposure caused by having money in a Roth IRA instead of an ERISA protected plan. 

The second profile is someone with incredibly high income currently and very little anticipated income in the future (such that their future tax rate is much lower than today’s rate). This too is a bit of a unicorn – people with high income today tend to have decent income tomorrow (even in the FI community).

Health Savings Accounts

It will also come as no surprise that I am fond of health savings accounts. Health savings accounts share some of the attributes that make the Roth IRA such a winner for both retirement savings and emergency planning.

But, there are some drawbacks. First, the distribution ordering rules are not as taxpayer friendly. While it may be the case that you have sufficient old medical expenses that you can reimburse yourself for (and thus not pay tax and a penalty on the HSA distribution), that is not always going to be the case, and even if it is, does add a layer of complexity.

Second, the HSA is not for everyone. If a high deductible health plan is not good medical insurance for you, an HSA is generally off the table.

So, that leaves the HSA as a fantastic option for those who qualify for and use a high deductible health plan (and usually an option that should be part of a comprehensive financial plan if you use a HDHP). But it also means that the HSA is not quite as good as a tool for the combination of retirement saving and emergency planning. 

Conclusion

Assuming that an individual (a) has retirement planning and emergency preparedness as financial planning objectives and (b) is not in a position where legal liabilities would cripple them without ERISA creditor protection, it is hard to argue against having at least some material amount in a Roth IRA. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Split-Year Backdoor Roth IRAs

Can I contribute to a Roth IRA? Can I do a Backdoor Roth IRA? These are two questions I often hear as a tax-focused financial planner.

Perhaps you find yourself preparing your 2020 tax return in early April 2021. You have not contributed anything to a traditional IRA or a Roth IRA yet for 2020. Do you have time to perhaps do a Roth IRA or a Backdoor Roth IRA? The answer is, “Absolutely!” if you have the right facts in place. Let’s discuss a comprehensive example:

Example 1: Jack is single, 35 years old, participates in a 401(k) at work, and has self-prepared his 2020 tax return but not yet filed it. It is April 9, 2021, and his tax-return software indicates that he does not qualify for a Roth IRA, as his modified adjusted gross income for 2020 is $150,000. Jack has no traditional IRAs, SEP IRAs, or SIMPLE IRAs. Jack just learned about the existence of the Backdoor Roth IRA. 

What can Jack do? Can he do a Backdoor Roth IRA for 2020? The answer is, Yes! 

First, Jack should, by April 15, 2021, make a traditional, non-deductible IRA contribution of $6,000. When he does this, he should designate the contribution as being for 2020. With his soon-to-be-filed 2020 federal income tax return, he should file a Form 8606 which will report the $6,000 traditional, non-deductible IRA contribution. Easy enough. 

Assuming Jack contributed to his 2020 traditional, non-deductible IRA in April 2021, in May of 2021 Jack should convert the entire balance in his traditional IRA to a Roth IRA. Third, he should ensure he has no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021. 

Jack can also do a Backdoor Roth IRA for 2021, which may be advisable if (a) his modified adjusted gross income exceeds the Roth IRA contribution thresholds and (b) he will have no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021. 

Assume Jack makes a traditional, non-deductible contribution to an IRA for 2021 on June 1, 2021, and on July 2, 2021, he converts the amounts in the traditional IRA to a Roth IRA. Further assume (a) the amounts converted in May and July were $6,001 and $6,002, respectively, and (b) Jack has no balance in traditional IRAs/SEP IRAs/SIMPLE IRAs as of December 31, 2021. 

When Jack files his 2021 tax return, Page 1 of his Form 8606 should look like this:

Page 1 of the Form 8606 reflects the total basis in traditional IRAs (without considering the Roth conversions). Note that I had to use the 2019 version of the Form 8606, as the 2021 version has not yet been released. Please adjust all dates in your mind’s eye accordingly.

Page 2 (reporting the 2021 Roth IRA conversions) of the Form 8606 should look like this:

The gross amount of the Roth IRA conversions are taxable, but Jack gets to recover his $12,000 of traditional IRA basis.

Post Tax Return Filing Split-Year Backdoor Roth IRA

Example 2: Jim is single, 35 years old, participates in a 401(k) at work, and has self-prepared his 2020 tax return and filed it on March 15, 2021. Jim’s modified adjusted gross income for 2020 is $150,000. Jim has no traditional IRAs, SEP IRAs, or SIMPLE IRAs. It is April 9, 2021 and Jim just learned about the existence of the Backdoor Roth IRA. 

Can Jim still do a Backdoor Roth IRA for 2020? Absolutely!

First, Jim should, by April 15, 2021, make a traditional, non-deductible IRA contribution of $6,000. When he does this, he should designate the contribution as being for 2020. So far, everything is the same as Example 1.

But here is where things change. Jim should also, by April 15, 2021, file a standalone Form 8606 with the IRS and be sure to sign the form on page 2. The Form 8606 will report the contribution to the traditional, non-deductible IRA. Jim will have to paper file the Form 8606 and mail it to the IRS Service Center that he would mail his Form 1040 to (if he were to paper file his Form 1040). 

Jim could then convert the traditional IRA to a Roth IRA to successfully complete the Backdoor Roth IRA. He should also ensure he had no balance in a traditional IRA, SEP IRA, or SIMPLE IRA on December 31, 2021. 

Advanced Split-Year Backdoor Roth IRA

Example 3: Jill is married to Joe, 35 years old, participates in a 401(k) at work, and has self-prepared their 2020 tax return but not yet filed it. Jill and Joe’s modified adjusted gross income for 2020 is $250,000. Jill has a traditional IRA with a balance of $100,000 (and no previous non-deductible contributions). It is April 9, 2021 and Jill just learned about the existence of the Backdoor Roth IRA. 

Jill’s example is a bit more challenging than Jack and Jim’s previous example. Yes, it is possible that Jill could successfully complete a Backdoor Roth IRA for 2020. But it involves much more execution risk – the risk that the proper steps will not be completed in time. While taxpayers engaging in any sort of tax planning should consider engaging professional assistance, Jill is in a position where that is even more so the case. 

Here is how Jill could successfully execute a Backdoor Roth IRA for 2020. Jill should go to her workplace benefits website and download and review the “Summary Plan Description” for the 401(k) plan (sometimes initialized “SPD”). 

It may be the case that Jill’s workplace 401(k) plan will accept a roll-in of her traditional IRA. Many 401(k)s do, but many do not. Some plans will only accept roll-ins of other qualified plans (401(k)s, 403(b)s, etc.), and some plans will only accept roll-ins of qualified plans and so-called “conduit IRAs” i.e., IRAs that consist only of money that was formerly in a qualified plan. However, there are some plans that will accept roll-ins of both old qualified plans and any type of traditional IRA (though note that in all events 401(k) plans cannot accept roll-ins of amounts representing non-deductible IRA contributions).

If Jill’s workplace 401(k) plan will accept a roll-in of the $100,000 traditional IRA, then Jill could transfer (in a direct trustee-to-trustee transfer) her traditional IRA (other than the amount of any nondeductible contributions, including a $6,000 2020 contribution) to the 401(k). If she fails to do that by December 31, 2021, then any Backdoor Roth IRA would be very tax inefficient (and unavisable) – you can read more here in the “Jennifer” example. 

This is one reason I say that there is “execution risk” – perhaps Jill does the “Backdoor Roth IRA” steps but neglects the transfer of the old traditional IRA to the 401(k) until after December 31, 2021. If that happens, Jill’s Backdoor Roth IRA will now be very tax inefficient.

Some might say “couldn’t Jill start a side hustle, open a Solo 401(k) for it, and then roll the traditional IRA into the Solo 401(k)?” To my mind, that is a dangerous path. Jill’s side hustle might not rise to the level of a trade or business for tax purposes. If it does not, then it is not eligible to have a Solo 401(k). Any transfer of a traditional IRA to a plan that does not qualify as either an IRA, 401(k), 403(b), or similar plan is simply a taxable distribution subject to full income tax and a 10 percent early withdrawal penalty. Ouch!!!

Jill should not over think it. If she can easily roll her old traditional IRA into her workplace 401(k), then she should consider doing so and doing a Backdoor Roth IRA. But if she cannot, then fine, there are plenty of other ways to become financially independent and/or achieve retirement planning goals. Not having the Backdoor Roth IRA tool available is no killer to her future plans and goals. 

Note further that if Jill’s balance was in a SIMPLE IRA that was less than 2 years old, she could not roll the SIMPLE IRA into anything other than a SIMPLE IRA for the first two years of her SIMPLE IRA’s existence without incurring a 25% penalty.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.