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By Linda Leatherbury, PhD, Full-Time Faculty, Kaplan UniversityPublished March 2015
Many individuals, especially baby boomers, have come to the conclusion that they can't rely on Social Security payments for their financial source during retirement. There is no denying that more individuals are at least thinking of alternative income streams for their retirement years. Just think about it: the combination of your retirement monies from your employer, your 401k distributions, and your Social Security payments sounds like that indeed should be enough of an income stream to survive comfortably through your golden years.
What may not have been foreseen was corporations getting out of the retirement funding business and insufficient funds in Social Security. The idea of funding an individual's retirement shifted from employer and the government to individuals. More and more of the conversation during the last 20 years has placed the onus of retirement on individuals. Thus the move toward individual retirement accounts. There are a plethora of different types of accounts. You have an alphabet of different types of plans such as Keogh, Sep-IRa, IRA, Roth IRA, etc.
Let's just focus on the Roth IRA. This personal retirement account was introduced by Senator William Roth and became law in 1997. (Roth J.D)
Many individuals who are setting aside their own retirement income are choosing Roth IRAs. In 2004, contributions to Roth IRAs were $14.7 billion, while contributions to traditional IRAs were $12.6 billion. These Roth IRAs are unique in that unlike other individual retirement accounts, taxes on these funds are paid when contributions are made rather when distributions are taken. This is referred to in the business as "after tax dollars." Since we in America don't believe in double taxation, you don't have to pay taxes when these funds are withdrawn. This is the sweetest aspect of Roth IRAs. There are many other legal requirements so, as always, you will want to consult your tax advisor before making investment decisions.
To contribute to these Roth IRAs there are various eligibility requirements. A Roth IRA is an IRA that, except as explained below, is subject to the rules that apply to a traditional IRA.
(Roth IRAs, 2015)
To contribute to a Roth IRA, there are income limits which must be met.
Modified AGI limit for Roth IRA contributions increased. For 2014, your Roth IRA contribution limit is reduced (phased out) in the following situations.
This approach is used to circumvent the contribution requirements limit of $191,000. Before this approach is discussed, be assured that it is NOT a tax loophole. Neither is it illegal. It is indeed supporting Mr. Roth's ideas of the Roth IRA. Remember the idea is for individuals to take control of their stream of income during retirement.
Why have the limits in the first place? What was congressional intent? Like most tax legislation it was put into place to assure that the "super rich" do indeed pay their fair share of taxes. Here is an example outlined from an article at Forbes.com:
"Max R. Levchin, chairman of social review site Yelp. In 2010 he sold 3.1 million shares of Yelp held in his Roth IRA. Most of the $10.1 million he received was profit. But Levchin, a 36-year-old serial entrepreneur who started PayPal with billionairePeter Thiel in 1998, won't ever have to pay a penny of income tax on those gains. That's because all earnings in a Roth IRA are tax free so long as its owner waits until age 59 1/2 to take money out."
Let's look at this scenario from the "back-door" approach. You open a traditional IRA or you use your current 401k funds and "convert" them into a Roth IRA account. There is NO income limit. That is perfectly legal—for now. Note you don't have to be a "CEO" of a large firm to open a traditional IRA account. So just think, if you are 16 and work at fast food restaurant you can open a traditional IRA account. You can continue to contribute until you graduate from graduate school, let's say at age 26. You can work your first 5 years in your profession until you turn 30, then convert your traditional IRA into a Roth IRA (provided tax laws haven't changed). When you retire in another 20 to 30 years those funds are ALL tax free.
Cellucci, R. (2014). When Is the Roth Conversion Optimal?. Journal Of Financial Service Professionals, 68(5), 94-100
Clayton, R., Clayton, L., Davis, L., & Fielding, W. (2014). Converting to a Roth IRA with Taxes Paid from Corpus of the Traditional IRA. Journal Of Applied Finance, 24(1), 111-116.
Roth, J. D. (2011). Eight Little-Known Facts About the Roth IRA. Retrieved from http://www.getrichslowly.org/blog/2011/09/15/eight-little-known-facts-about-the-roth-ira/
Jacobs, D. (2012). Why-and How-Congress Should Curb Roth IRAs. Forbes.com. Retrieved from http://www.forbes.com/sites/deborahljacobs/2012/03/26/why-and-how-congress-should-curb-roth-iras/
Roth IRAs. (2015, January 28). Retrieved from: http://www.irs.gov/Retirement-Plans/Roth-IRAs
Linda Leatherbury is a full-time faculty member at Kaplan University. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.Consult your advisor before making investment decisions.
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