It is a delicious bit of irony that the high-income earners who usually foot a disproportionate share of the federal income-tax bill are also (by definition) precluded from funding a Roth IRA.
Therefore, their income-tax rate during retirement may be at the same level (or higher) than what it was while they were toiling away — especially if you've earned a respectable return on their tax-sheltered investments.
But you can help those “cursed” with a higher income retire with a good sum tucked away in their respective Roth IRAs — in some cases with a lot more than what these mega-money makers could have otherwise accumulated through the relatively paltry annual deposits.
Last month we covered why Roth IRAs will be so valuable to your retiring clients. Here are three ways to help earners in the upper echelon get some tax-free retirement income, too.
The Plan At Work
In 2008, only those married filers with modified adjusted gross income below $169,000 ($116,000 for single) can deposit money into a self-directed Roth IRA. Even then, the maximum contribution that can be set aside in those accounts this year is $5,000 ($6,000 for those willing to admit they are over 50).
But your clients making more than these amounts might still be able to eventually get money into a Roth IRA, as long as they work for the 22 percent of employers that the Profit Sharing/401(k) Council of America says are offering Roth 401(k) investment plans to employees.
The Roth 401(k) has a couple of legs up on the self-directed Roth IRA. First, the limits on contributions are the lesser of the employee's earnings, or $15,500 ($20,500 if the worker is over 50). Second, and most importantly, there is no earnings limitation determining who can make a deposit.
Even with these advantages, you may still be tempted to dismiss the notion of your high- salaried earners using a Roth 401(k), on the grounds that since contributions are after-tax, the deposits won't reduce your clients' tax bill one bit in 2008.
But the extra tax dollars your client pays now may buy her many times that amount in tax-free dollars during retirement. Which could look even better if it helps her avoid mandatory minimum withdrawals, taxation on her Social Security payments, or a return to the mid- and high-double-digit income tax rates we endured a generation ago.
Undergoing A Conversion
In recent years, the tax laws have been tweaked to encourage more people to convert IRAs to Roth IRAs. The move may make sense for some of your high-income clients now, and many more of them when 2010 rolls around.
First, why now? Conversions are only available for taxpayers who make less than $100,000 in modified adjusted gross income (MAGI). That number holds true for both single and married joint filers.
Although the proceeds from the conversion are taxable as ordinary income, they do not count towards the $100,000 number. So a client with, say, $90,000 in MAGI could theoretically convert millions from an IRA to a Roth IRA, as long as she's willing to pay the taxes on the conversion.
“But, wait!” you shriek. “Isn't this column about how to get Roth IRAs for rich retirees?” Yes, but temporary circumstances (such as time off from full-time employment) could allow a lifelong high earner to slide under the income bar in a particular year.
The Real Party Starts In 2010
That's when, courtesy of the Tax Increase Prevention and Reconciliation Act of 2006, IRA owners can convert the accounts to Roth IRAs, regardless of income or filing status.
Better yet, if the law holds as written, converters in that year can spread the ensuing tax bill out over 2011 and 2012.
Whether your client makes a Roth IRA conversion now, or after 2010, keep in mind that although the client won't have to pay a 10-percent pre-59½ penalty on converted amounts, he will have to pay income taxes.
It usually works better if the client can pay those taxes from non-retirement assets, as money withdrawn from the IRA to pay for the conversion could be subject to the 10 percent penalty if the client is under 59½.
Talk With Mom And Dad
Say your 50-year-old high-net-worth client has 75-year-old parents with $100,000 in their IRAs. Your client is the only beneficiary of the IRAs, and his folks have a few hundred thousand dollars in other non-sheltered accounts.
Generation-transcending benefits can be had if the parents convert their IRAs to Roth IRAs. The parents get to avoid the nuisance (and taxes) of escalating “required minimum distributions,” as well as having those withdrawals bring the folks' Social Security payments closer to taxation during future years, too.
The son's good fortune will be realized when he inherits any remnants in the converted account. The IRS says he will have to begin drawing money from the accounts according to his life expectancy.
But, at least initially, the RMD on his inherited Roths will be only a percentage or two of the balance each year. The remainder can accumulate tax-free for decades to come.
In fact, your client may even be inclined to offer to pay his parents' ensuing tax bill from the conversion. If so, keep in mind that he may be subject to gift tax issues if he gives either of his parents more than $12,000 in any calendar year.
Don't Try This Alone
As you might have guessed, the above strategies shouldn't be attempted without the involvement of the client's tax preparer.
If you want to bone up on some of the ins-and-outs of the Roth, though, a couple of great sources are Kaye Thomas's website (www.fairmark.com), and his book Go Roth! Also, Ed Slott provides some wonderful technical and strategic information at www.irahelp.com.
My guess is those making too much to open a Roth IRA wouldn't trade their extra earnings in exchange for the pleasure of tax-free income after 59½. But with your help, it's a hypothetical choice they won't have to make.
How Much Difference Can The Roth 401(k) Make?
Let's say you have a 50-year-old high-income client putting $15,000 per year into her at-work 401(k). She has a blended tax rate of 35 percent, both now (federal, state and capital gains), and after she retires at 65. She'll also earn 8 percent annually on the money in the plan, both before and after retirement.
If she switches to the Roth 401(k) for the next 15 years, she'll have about $435,000 to take out tax-free at age 65. But if she sticks with the regular 401(k), she'll have about $32,000 less at 65 — even if she invests the annual tax savings provided by the regular 401(k) into a taxable separate account.
Writer's BIO: Kevin McKinley CFP© is Principal/Owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid a Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. You can reach him at [email protected].