Dear Liz: I was in the twilight of my career when the Roth became available, and I contributed the maximum for those few years before retirement. After retirement, I dropped to the 15 percent tax bracket, so I did Roth conversions of my regular IRA to fill out that tax bracket until I was age 70½. My reasoning was that I would likely be in the 25 percent tax bracket when I started my required minimum distributions from my IRA, and that turned out to be true.
The scary part is that the tax-deferred money in the rollover IRA has continued to increase each year in total in spite of the required minimum distributions. My tax preparer says he has clients who would be happy with my problem, so I should tread softly with my tax complaints.
One thing I regret is funding a nondeductible IRA for a few years before the availability of the Roth IRA. The nondeductible contributions only represent about 1 percent of the total. That means I can’t access that money I have already paid taxes on unless I have depleted all of my tax-deferred monies. Do you have any suggestions?
Answer: Absolutely. Listen to your tax preparer. Most retirees would love to have these problems-that-aren’t-really-problems.
You were smart to “fill out” your tax bracket by converting portions of your IRAs. For those who aren’t familiar with the concept, it involves converting just enough from an IRA to make up the difference between someone’s taxable income and the top of his or her tax bracket.
The top of the 15 percent bracket is $75,900 in 2017, so a married couple with a $50,000 taxable income, for example, would convert $25,900 of their IRAs to Roths. They would pay a 15 percent tax on the amount converted (plus any state and local taxes), but the Roth would grow tax-free from then on and no minimum distributions would be required.
These conversions can be a great idea if people suspect they’ll be in a higher tax bracket in retirement.
Now on to your complaint about getting back the already taxed contributions to your regular IRA. Withdrawals from regular IRAs are taxed proportionately.
The amount of your after-tax contributions is compared to the total of all your IRAs, and a proportionate amount escapes tax. So if nondeductible contributions represent 1 percent of the total, you’ll pay tax on 99 percent of the withdrawal. You’re accessing a tiny bit of your after-tax contributions with each withdrawal.
If you don’t manage to withdraw all the money, that’s not the worst thing in the world. It means you didn’t outlive your funds. Your heirs will inherit your tax basis so they’ll access whatever you couldn’t.
Dear Liz: In a column that ran in my local newspaper, you stated that, “Roths allow you to withdraw the amount you’ve contributed at any time without triggering income taxes or penalties.”
I suggest that you review Pub. 590-B, where you will be reminded that, with some exceptions, withdrawals from a Roth IRA within the first five years will result in a 10 percent penalty.
Answer: The five-year rule applies only to earnings, not contributions. The IRS publication you reference states on page 30, “You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s).” There’s a helpful diagram on page 32 that explains when a distribution is made within five years of the year in which the Roth is opened, the “portion of the distribution allocable to earnings may be subject to tax and it may be subject to the 10 percent additional tax.” (Emphasis added.)
Retirement distribution rules can be complex and it’s easy to make a mistake. But the fact that people can withdraw their Roth contributions at any time without taxes or penalties is not some obscure facet of these retirement accounts. It’s a central feature.
Unlike regular IRAs, where withdrawals are taxed proportionate to their earnings, a withdrawal from a Roth IRA is deemed to be from nondeductible contributions first. People have to withdraw more than they contributed to face a tax bill or penalties. If they’re over 59½ and the account has been open five years, their withdrawal of earnings will be tax-free and penalty-free.
Liz Weston, certified financial planner, is a personal finance columnist for NerdWallet. Questions may be sent to her at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com. Distributed by No More Red Inc.