Roth IRAs are powerful retirement savings tools — if used correctly. Unfortunately, many advisors and their clients hold beliefs about Roth IRAs that are downright wrong. These misguided beliefs can lead to negative consequences, including passing up planning strategies that could save valuable tax dollars for clients during retirement. With that in mind, here are 5 Roth IRA myths you simply can't afford to believe.
1. Your client is too old to convert to a Roth IRA.
Please, can we once and for all get rid of the notion that age has anything to do with whether or not your client should convert to a Roth IRA?! It doesn't!
That's not to say that, on average, a Roth IRA conversion will make sense for the same number of 80 year-old clients as it does for 40 year-old clients. It doesn't. But that's not due to a client's age so much as it is other factors, including current vs. future expected tax rates.
That said, there are plenty of reasons why clients in their 70s, 80s or older should consider making a Roth conversion. For instance, making a Roth conversion might increase income in the year of conversion to the point where a client is forced to pay higher Medicare Part B premiums (generally two years later). But that added conversion income is a one-time occurrence.
Without the conversion, higher Medicare Part B premiums might be an every-year issue once required minimum distributions (RMDs) begin if no conversion is made. Advisors must consider Part B premiums and other issues, including the taxability of an increased portion a client's Social Security benefits, in any Roth conversion analysis.
Picture another scenario: clients who are 70 or 80 years old, are in a low income tax bracket, but have still-working beneficiaries who are in higher tax brackets. Converting now, using clients' lower bracket, can help minimize the cumulative tax bill that will be owed on their retirement savings.
As you can imagine, there are any number of possibilities, but the point is simple: Just because a client is 75 or 80 doesn't automatically make him or her "too old" to benefit from a Roth IRA conversion.
2. There is a five-year waiting period to take distributions.
No, there's not. If I had a nickel — or more realistically, a five dollar bill — for every time I've heard an advisor say this, oftentimes to a client, I could probably make my entire 2015 IRA contribution! When it comes to IRAs, including Roth IRAs, clients are always 100 percent vested in their funds. And, from the tax code's perspective, there is absolutely no waiting period required before distributions may be taken. Of course, a client's investment option could impose its own liquidity rules, but that has nothing to do with the tax code or tax rules.
So why the confusion? There are two Roth IRA 5-year rules that you may have to deal with. But here's the thing: Neither of them has anything to do with preventing a client from taking money out of a Roth IRA! Instead, those rules just deal with the tax consequences of the Roth IRA distributions they take. Myth busted.
3. Clients must be age 59 ½ to access Roth IRA money tax- and penalty-free.
In general, clients must be age 59 ½ and have established a Roth IRA at least five years ago in order for Roth IRA funds to be tax- and penalty-free for life. But just because not everything in your client's Roth IRA is tax free yet, it doesn't mean that none of their Roth IRA money is.
Not that it's a good idea, but in many situations your clients can put money into a Roth IRA today, then use it tomorrow without tax or penalty — regardless of their age or the reason for their withdrawal.
Simply put, Roth IRA contributions can be distributed at any time without incurring a tax or penalty. And here's the even better part: Your client's Roth IRA contributions are always considered to be the first money out of their Roth IRA (for distribution purposes all of your client's Roth IRAs are treated as one account).
Every dollar of contributed money comes out tax- and penalty-free before a single dollar of earnings —which may be taxable and/or subject to a 10 penalty — is distributed. Funds that have been converted to a Roth IRA often receive the same tax treatment.
They are always tax-free. After all, your client paid the tax on those funds when they made their Roth conversion, right? In addition, they will also be penalty free if your client's conversion took place more than five years ago or if they are already over 59 ½.
4. Roth IRA calculators provide consistently realistic projections.
Have you ever questioned whether a Roth IRA contribution or conversion was right for your clientd or if they'd be better off making a traditional IRA contribution and getting a deduction? If so, then chances are you've wondered if there was a simple calculator that could take all your client's pertinent data, analyze it, and then, like a "Magic 8 Ball" of Roth planning, spit out a definitive "yes" or "no," telling you the correct course of action.
Unfortunately, that's generally not going to be the case. Don't get me wrong, calculators of all types, including Roth IRA calculators, can be wonderful tools and have their place in helping you evaluate the merits of a particular transaction for a client. But they are also often highly unrealistic when modeling what actually happens in the real world, with real clients. Here's a prime example of what I mean:
In order to make a fair, apples-to-apples comparison, most should-a-client- go with-a-Roth-IRA-or-traditional-IRA software compares the projected future value of a client's Roth IRA account to the projected future value of a client's traditional IRA account, plus the projected future value of a taxable account that represents the funds that would have otherwise been used to pay the tax on the Roth money at the time of contribution/conversion.
