IRAs, Roth IRAs, 401(k)s are among the very basics of building a financial plan, and they apply to just about everybody. On this episode of Your Life Simplified, Valerie Escobar, senior wealth advisor, is joined by Jodi Robinson, vice president of tax services. They discuss the differences between Roth IRAs and Roth 401(k)s, required minimum distributions and Roth conversions. 

Transcript

Valerie Escobar: IRAs, Roth IRAs, 401(k)s—these are all the very basics of building a financial plan that applies to just about everybody. This is something that we almost take for granted as being common knowledge, but it’s not. We wanted to really dig into just demystify specifically the Roth and the Roth 401(k).

Welcome to Your Life Simplified. Today, our guest is Jodi Robinson, VP of Tax Services. Jodi, thank you for having us.

Jodi Robinson: I’m glad to be here.

Valerie: Really, thanks for joining us, but I could be your guest, of course.

Jodi: Whatever works for me.

Valerie: Awesome. Jodi, thank you so much for joining us. Like I said, we are talking about Roth IRAs, but so many people ask me, “What is the difference between a Roth and a traditional IRA?”

Jodi: I’m actually going to start explaining that by talking about a non-Roth.

Valerie: Perfect.

Jodi: Traditional IRAs, there are traditional deductible IRAs, which means that you are getting a tax deduction upfront for that contribution, and then it grows tax deferred going forward. A traditional, non-deductible contribution is actually no tax deduction upfront, but going forward, it grows tax deferred. Now, a Roth, similar type of account, you’re using after-tax dollars to make your Roth contribution. You’re essentially forgoing your tax deduction upfront, but the power of the Roth lies in the fact that it is going to grow tax free. To repeat, traditional IRAs are tax deferred, Roth IRA is tax free.

Valerie: Let’s say, for example, we’ll use really round numbers, somebody makes $15,000, and they decide that they’re going to contribute $5,000 into a traditional IRA. How much of their income are they paying taxes on for that year?

Jodi: A traditional deductible IRA?

Valerie: A deductible IRA, yes. That’s a great differentiator.

Jodi: Using those basic round numbers, they would then be paying tax on $10,000 because they’d have $15,000 of income minus that deduction for the contribution that they made.

Valerie: Perfect. Then, as you said with the Roth, you don’t take a deduction. It’s all that $15,000 paying taxes on, but then in the future that $5,000 grows in a Roth tax free. Go back to the deductible, non-deductible IRA. Why would somebody make a non-deductible IRA contribution?

Jodi: There are income limits that come into play in all of these contributions, with the exception of a non-deductible. Anyone can make a non-deductible contribution as long as they have earned income. But not everyone can make a deductible contribution and not everyone can make a Roth contribution because of those income limitations.

For 2024, when we’re talking about a Roth, those income limitations set by the IRS and adjusted for inflation every year are for a single taxpayer, $161,000. And for married filing joint it’s $240,000. As long as your modified adjusted gross income is below those thresholds, you can make a full or partial Roth IRA contribution. If it’s above, you cannot make a direct Roth contribution.

Valerie: I think that’s a lot of numbers and rules and regulations, can we say that, really, it’s a choice between a deductible, traditional IRA and a Roth IRA contribution? Would you agree that those are the first two most important ones?

Jodi: Yeah.

Valerie: The non-deductible, let’s talk about that later. But really, I guess it’s like, “Talk to your advisor, talk to your tax person.”

Jodi: Absolutely. You want to make sure that you’re getting it into the right account.

Valerie: Perfect. One of the big things that differentiates an IRA or an IRA, as some people call it, and a Roth IRA are another acronym, RMDs.

Jodi: Correct.

Valerie: Tell me about an RMD. What is an RMD?

Jodi: RMD stands for required minimum distribution, and those kick in for someone in 2024, if you’re turning 73 in 2024, the IRS mandates that you start making withdrawals from your IRA. They’ve allowed you to let it grow tax deferred for years, but an RMD is the government’s way of ensuring that you’re ultimately going to pay tax on that. To calculate the RMD each year, you’re taking the collective balances of your traditional IRA accounts, and then applying a life expectancy table to that to determine the amount that you need to withdraw.

Now, it gets tricky, because if you don’t take the amount, if you under-distribute or you just skip it altogether, there is an excise tax that the IRS will assess at 25% of that under-withheld amount. Let’s say for example, $20,000 is the amount you should have taken for your RMD, you missed it, 25% of that is a pretty hefty penalty of $5,000. You need to make sure that you’re following the RMD distribution rules.

Valerie: As if it wasn’t complicated enough, now they’ve got a really stiff penalty on top of it for not doing it. With those, now as you said, it’s 73, it used to be 71 and a half, and I think it went to 72. Anyways, lots of law changes, right?

Jodi: It’s been hard to keep up with.

Valerie: Again, that’s something that you or I in our positions that we can help clients with. But another part of those recent tax changes was regarding the Roth 401(k). And let me back up a little bit. We’re talking about required minimum distributions, and you’re talking about taking it from a collective of your traditional IRAs. What about 401(k)s? Maybe let’s start there. How do required minimum distributions apply to traditional 401(k)s?

Jodi: Same as they do for traditional IRAs. Traditional IRAs have that RMD requirement, a Roth IRA does not. A traditional 401(k) also has those same RMD requirements. A Roth 401(k) with the SECURE Act that came about a couple of years ago, beginning in 2024, you actually do not have to take an RMD from a Roth 401(k). That puts a Roth 401(k) on the same playing field as a Roth IRA now. That was another confusing point previously, “Do I need to take an RMD, do I not with a Roth?” Now Roth 401(k)s are the same as a Roth IRA, there is no RMD requirement.

Valerie: Perfect. Previously, we would have to do a rollover or something out of that 401(k) plan.

Jodi: Yes, there were ways that you could get around that by doing some rollovers, but you don’t need to get tricky anymore.

Valerie: Finally, there’s one great thing.

Jodi: Exactly.

Valerie: With those Roth IRAs not having to take those RMDs, that really becomes a planning, I think, opportunity because sometimes clients will say, “My required minimum distribution is $100,000 and I really only need $50,000 to live off.” What would be a way to reduce the amount of required minimum distribution by using a Roth, for example?

Jodi: Because the RMD requirements are on traditional IRAs, we would work to strategically reduce the balance of your traditional IRAs by doing Roth conversions. We won’t get down into the nitty-gritty details of that on this podcast because that could be an entire episode.

Valerie: An episode of its own thing, yes.

Jodi: But high level, you are strategically converting all or part of your traditional IRAs, possibly over a period of time to help manage the taxes, converting those to a Roth. Now when you convert, you’re paying the tax as you convert, but you’re then banking on the future tax-free growth from that point. That’s how you can reduce the RMDs on your traditional balances is by slowly draining those and converting them to a Roth.

Valerie: Great. It’s like, “I’m going to pay my taxes now so that I don’t have to later.” And then maybe one point I’d add in, when I have a client, for example, they want to be moderate, a little bit of growth, a little bit that’s conservative, I’ll put the conservative stuff in a traditional IRA and then really let the aggressive stuff grow in that Roth because that will tax free.

Jodi: Absolutely. But I would say, just to jump in here, that the Roth conversions are definitely something that you need to work with your advisor on because there’s so much planning and strategy that goes into timing of it, managing tax brackets, determining the amounts that you’re actually going to convert. It’s not something that you want to venture into on your own without having your advisor do those planning scenarios with you.

Valerie: Thank you for mentioning that because one of the things, too, conversations that I will get into is, “How are we going to pay the taxes?” It’s like, “I’m converting 100,000.” Guess what? Let’s say it’s $25,000 worth of taxes. Should we withhold that from the IRA? What are the potential implications?

Jodi: In general, you want to have funds outside of the IRA account to pay the taxes. There could be some limited situations where it might still be beneficial, but general advice is have those funds available to pay the tax outside the Roth IRA so that you’re not actually infringing on the balance of the IRA that you want to grow going forward.

Valerie: Perfect. Last thing we want to do as advisors is create a tax surprise like, “Guess what? Part of our strategy is you’re getting surprised with a $25,000 tax bill.”

Jodi: Exactly. Because there are no do-overs on Roth conversions anymore. That used to be an old rule where you could actually recharacterize, but that is gone. Now once you convert an amount, you’ve converted.

Valerie: You’ve converted.

Jodi: You’ve committed. That’s why you need to make sure that you are thoroughly planning for all of the consequences of that.

Valerie: Perfect. Great point. One of the things that we were talking about with conversions, this is where I want to talk about when those non-deductible IRA contributions might come into play, is doing what we call backdoor Roth contribution. Can you talk about what those are?

Jodi: The backdoor Roth is another strategy for those high-income taxpayers who can’t make a direct contribution to a Roth. We talked about those modified adjusted gross income limits before. If you’re above those limits, you can still get dollars into a Roth by doing the backdoor, which is starting with a traditional non-deductible contribution, and then converting those amounts working to minimize the tax cost as you convert those.

Once you then get them converted into a Roth, again, they’re growing tax free going forward. But, caution tape here, this is another one where you definitely want to be working with your advisor because you can easily get tripped up if you have existing traditional IRAs out there and if you just don’t follow all of the steps in sequence. Again, something that you should consult an advisor because there’s a lot of booby traps.

Valerie: This is not a loaded question because you already know the answer to it, but let’s say I have $100,000 in a traditional IRA that I’ve held forever, and it was all funded with pre-debt tax dollars, and then I’m thinking, “I want to do a backdoor Roth contribution, but I don’t want to pay taxes, and I’m going to leave that IRA alone and I’m going to make a non-deductible IRA contribution to a brand new IRA and then convert that.” What’s wrong with that?

Jodi: The problem is that by having a traditional IRA out there with pre-tax dollars, the IRS says that you can’t then just convert those new amounts that you contributed, you also have to factor in what’s going to be a taxable portion of those already-existing IRAs. It’s called the pro-rata rule, where you have to bring in a portion of those existing IRAs into the tax calculation.

Valerie: It’s like the punch is already mixed up. The Kool-Aid and the water, it’s all together, you can’t just separate them, the IRA.

Jodi: You might think that you’re preparing to do a non-taxable backdoor conversion, and the surprise could be that, well, actually most of that is taxable because you already had an existing IRA out there. Again, that’s why you need to make sure that you’ve got all your ducks in a row.

Valerie: Definitely caution on when doing that. Jodi, thank you so much for joining us today. You’ve been listening to Your Life Simplified. Be sure to catch us wherever you tune in, Spotify, Apple, YouTube, and we will see you next time.

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