As a financial advisor, you know the Roth IRA provides a number of benefits to clients saving for retirement, including tax-free growth, no required minimum distributions for those age 70½ and older, and the option to continue contributions beyond the age of 70½ (if income is still being earned). But in order for your clients to reap these benefits, it’s essential that you maintain an understanding of the rules of Roth IRA contributions, as there are a number of penalties your clients could face if their accounts are not carefully monitored. Below, I will discuss two common Roth IRA pitfalls, as well as how best to avoid them.
The scenario. Your 34-year-old client, Steve, is single and normally earns a salary of around $100,000, so he has been advised to max out his Roth IRA contributions at the end of each year. In 2017, however, Steve earned $110,000, as well as an unexpected holiday bonus in the amount of $30,000. Not thinking anything of it, Steve made his full $5,500 contribution in December.
The problem. Unfortunately, Steve was not aware of the income phaseouts that exist for Roth IRA contributions. For the 2017 tax year, the lower modified adjusted gross income (MAGI) threshold is $118,000, and the upper MAGI threshold is $133,000. This means individuals who earn less than $118,000 can make the full $5,500 contribution to a Roth IRA; individuals who earn more than $133,000 cannot contribute at all; and individuals whose income falls somewhere in the middle of the lower and upper MAGI thresholds can make a partial contribution.
When Steve sits down with his accountant to go over his 2017 tax return, they soon realize that because of the bonus he received late last year, his MAGI is well over $133,000, which makes him ineligible to contribute to a Roth IRA. If he leaves the $5,500 contribution in the Roth IRA, the IRS could impose a 6-percent excise tax each and every year that the contribution sits in the account. Now what?
The solution. To avoid this common Roth IRA pitfall, Steve can choose one of two ways to move the $5,500 contribution out of his Roth IRA and eliminate the IRS excise tax:
- Option 1: Request a return of excess contribution. Steve has until his tax-filing deadline (including extensions) to remove the $5,500 contribution (plus gains or losses) from the Roth IRA before incurring any penalties. The money would then be sent right back to Steve. Keep in mind the earnings are subject to potential taxes and/or penalties.
- Option 2: Request a recharacterization. Like in option 1, Steve has until his tax-filing deadline to remove the contribution (plus gains or losses). But instead of having the money sent directly back to him, he could recharacterize those proceeds to a traditional IRA, as if the contribution had been made to the traditional IRA all along. With this option, there would be no taxes and/or penalties owed on the earnings.
Roth IRA Conversion
The scenario. Your new client, Bridget, is in her late 40s and has been making nondeductible contributions to her traditional IRA. She called recently to ask about a Roth IRA conversion, and you discussed the benefits converting her traditional IRA to a Roth IRA could offer:
- She has $30,000 in her traditional IRA, $1,000 of which is attributed to earnings.
- She has made only nondeductible contributions to her traditional IRA, so the taxes on the assets converted would apply only to the earnings.
- She is in the 25-percent tax bracket, so she would need to pay just $250 in taxes on the conversion. (Not a bad tradeoff for tax-free growth!)
After discussing these benefits, on January 19, 2018, Bridget requests that you convert the assets in her traditional IRA to a Roth IRA.
The problem. A few days later, Bridget calls you to check in on the status of the conversion. After chatting for a few minutes, you find out that Bridget has a large balance of around $100,000 in a SEP IRA from her old employer that she never told you about. Under the pro-rata rule, the calculation for taxes owed on the conversion is based on the ratio of nondeductible contributions to the market value of all IRA account balances, including SEP and SIMPLE IRAs. In other words, if nondeductible assets are converted from a traditional IRA to a Roth IRA, and the investor holds other IRAs, it is assumed that the conversion amount comes prorated from the aggregate amount of money in all of the investor’s IRAs. So now, instead of owing $250 in taxes, Bridget will need to pay closer to $7,000.
The solution. If this conversion had taken place prior to 2018, Bridget would have had until her tax-filing deadline (plus extensions) to recharacterize the Roth conversion back to the traditional IRA and eliminate the amount owed in taxes. The new Tax Cuts and Jobs Act of 2017, however, prevents investors from recharacterizing Roth conversions made after December 31, 2017. This means Bridget’s assets are stuck in the Roth IRA, and she will have to pay the resulting taxes.
To avoid this common Roth IRA pitfall, be sure to review all potential consequences with your clients when moving money into a Roth IRA, particularly if they are considering a Roth conversion.
Educating Your Clients—and Yourself
If you have a client in a situation similar to Steve’s, fortunately, there are ways to correct the problem at hand—just be sure to request a return of excess contribution or recharacterization prior to the client’s tax-filing deadline. I hope none of your clients have experienced the same pitfall as Bridget, but do let this example serve as a reminder to be sure your new clients (and your existing ones!) make all of their investments known to you, even ones they might not consider relevant. Had Steve and Bridget simply discussed their situations in more depth, the problems they both faced could have been avoided easily. Steer clear of pitfalls like these by educating yourself and your clients on the Roth IRA rules and discussing all potential investment outcomes and consequences with clients before any money is moved.
Have your clients run into common Roth IRA pitfalls like these? How do you educate your clients on their eligibility to make Roth IRA contributions and conversions? Please share your thoughts with us below.
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.