From the advisors at Collegiate Capital Management, Inc.
The UNC System and the State of North Carolina have embraced recent Roth-related changes to the IRS code. UNC System employees can now designate contributions to three supplemental retirement accounts (SRAs) as post-tax Roth contributions.
Earnings on Roth assets are not taxed if withdrawals do not begin until at least five years after the initial deposit. Roth assets can provide more flexibility in portfolio management, reduce tax liabilities and provide an additional estate planning tool.
If you are age 50 or older, you may contribute as much as $46,000 annually to Roth SRAs, regardless of income. In contrast, IRS rules limit your contributions to a Roth IRA to a maximum of $5,500 for those under age 50 and $6,500 for those age 50 and older. Your income could further limit your annual contributions.
Required minimum distributions (RMDs) are not required to be taken by the original account owner of a Roth IRA. However, you must begin taking RMDs from university-sponsored Roth accounts at age 70 1/2. This requirement can be avoided by rolling over the assets to a Roth IRA when university and IRS rules allow – generally at age 59 1/2 or termination of employment.
It is impossible to predict how individual tax structures and rates will change, capital gains and dividends will be treated, or social security benefits will be taxed in the future. These uncertainties can be better managed by having some of your retirement assets in Roth accounts.
Many individuals base their decision to fund Roth accounts solely on the potential differences in tax rate between the contributory and withdrawal periods. However, Roth assets can also add tax efficiency to your retirement portfolio in other ways.
If you have post-tax assets that are intended for retirement, and monthly cash flow will not allow Roth contributions, consider using these post-tax assets to fund your Roth accounts. You can make payroll contributions to a Roth account and replace the lost take-home pay by withdrawing the same amount from your post-tax account. By converting these dollars into Roth assets, you will be able to completely avoid taxes on their future earnings rather than paying capital gains or taxes at your income tax rate.
Generally, RMDs must begin from pre-tax retirement accounts at age 70 1/2. Continuing to make pre-tax retirement plan contributions can overweight your pre-tax assets in later years. In some cases, the magnitude of RMDs could cause your taxable income to be taxed at the same or higher rate than when the contributions were originally made, running counter to your original premise. Also, RMDs can exceed your income need, resulting in undesirable taxable income.
Because Roth assets are not subject to RMDs by the account owner, earmarking your contributions as Roth will decrease the total required distributions from your pre-tax accounts. As a result, withdrawals from your pre-tax accounts may be taxed at lower rates than when the contributions were originally made.
If there is a chance your children or grandchildren will inherit some of your retirement assets, Roth accounts will help them avoid future tax burdens. Although they must begin taking required distributions from Roth accounts after your death, the assets will continue to grow tax-free and withdrawals will not be taxed.
Because withdrawals from Roth accounts are not included in adjusted gross income (AGI), you could increase your allowable deductions and reduce your taxable income by using Roth assets to (at least partially) fund your retirement income. (Note: You may claim miscellaneous itemized deductions that exceed 2% of AGI from your taxable income. Medical expenses and casualty losses are subject to a higher threshold.)
Qualified dividends and long-term capital gains in post-tax accounts are taxed at 0%, 15% or 20% depending upon your marginal tax bracket. Because withdrawals from Roth accounts are not part of your AGI, Roth assets could be used for retirement income and thereby help you reduce or avoid taxes on long-term capital gains and dividends in some years.
Once retired and receiving a social security benefit, the percentage of benefit that is taxed depends upon your AGI. Because distributions from Roth accounts are not included in AGI, you may be able to reduce the taxable portion of your social security benefit. This is a particularly useful approach in the years between retirement and the attainment of age 70 ½ when RMDs from pre-tax assets begin.