Advanced Roth Strategies—Part II of II
Good to Know
This article continues our goal to create or deepen a financial advisor’s awareness of the creative use of Roth IRAs or Designated Roth Accounts in special circumstances such as:
- Resolving the tension between building an emergency reserve and saving for retirement,
- Reducing income taxes on Social Security Benefits for retirees, and
- Lowering adjusted gross income to save on Medicare premiums.
Caveat—this article is meant to raise awareness only and should not be used to provide financial advice. The strategies summarized below are complex and should be considered only through consultation with a credentialed tax professional experienced in these techniques.
Resolving the Tension
CFP Board recommends establishing a cash reserve for emergencies equal to three to six months of required monthly expenses. Three months is generally recommended for dual-income families and six months is recommended when just one spouse works outside of the home. If monthly required expenses for a young family equal $5,000, an emergency reserve of as much as $30,000 is appropriate. That recommendation becomes urgent when we consider that 5 in every 10 Americans have less than a three-month reserve and—alarmingly—25% have NO emergency reserve saved.1
Here's how to kill two birds with one stone—clients can contribute to a Roth IRA to begin saving for retirement and create a pool of emergency cash simultaneously. How does that work? Clients can withdraw their original contributions to a Roth IRA at any time without income tax or penalty.2
Reducing Income Tax on Social Security Benefits
Picture this—you’ve worked a lifetime, you’re nearing retirement, and you’re counting on your promised Social Security retirement benefits. As a reminder, you received no income tax deduction for the Social Security taxes withheld from your paychecks. Yet, if your retirement income exceeds the levels in the chart below, you’ll have to pay income taxes on your Social Security benefits. That’s downright unfair in the author’s opinion, but it is regrettably what it is.
What could that observation possibly have to do with Roth distributions in retirement? Unlike Traditional IRA distributions, income-tax-free Roth distributions are not counted as “combined income” in the chart below. Here’s the takeaway, qualifying Roth distributions are income tax-free in and of themselves and can even serve to reduce income tax on Social Security benefits as well!
|FILING STATUS||COMBINED INCOME||BENEFITS SUBJECT TO TAXATION|
|Single||$25,000 - $34,000
$34,000 and above
|Up to 50%
Up to 85%
|Joint Return||$32,000 - $44,000
$44,000 and above
|Up to 50%
Up to 85%
Lowering Medicare Premiums
When would anyone ever overpay for health insurance premiums? A client may unknowingly overpay Medicare insurance premiums whenever they fail to take advantage of the Roth IRA. Here’s how that works:
- Premiums for Medicare Parts B and D are means-tested,
- Means testing is a term applied to the increase in premiums based on an individual’s or couple’s income,
- Medicare Part B covers physician services and outpatient care,
Medicare Parts B and D premiums vary dramatically based upon your client’s income—clients with relatively high income will pay as much as three times the premium amounts paid by clients with relatively low income.
The Bottom Line
Yet more savings are possible by choosing Roth IRAs or Designated Roth Accounts over Traditional IRAs or pre-tax qualified plans to reduce adjusted gross income and pre-tax income. Without taking our readers into the Internal Revenue Code “weeds,” tax-free Roth distributions can:
- Reduce the Net Investment Income Tax,
- Preserve income tax credits that phase out based on adjusted gross income, such as the American Opportunity Credit, Lifetime Learning Credit, Adoption Credit, and
- In some states—reduce income-based property taxes.
In closing, note this caveat—these ideas should be considered as a part of a broader retirement and tax-minimization strategy conducted by credentialed experts.
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide legal, identity theft protection, investment, income tax, risk management, retirement, estate, or financial planning advice of any kind. An experienced and credentialed expert should be consulted before making decisions relating to the topics covered herein. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
1 Retrieved from: https://www.bankrate.com/banking/savings/emergency-savings-survey-july-2021/
2 Assumes original contributions. Be aware that contributions from a Roth conversion are available for income-tax-free distributions but are subject to a 10% nonqualifying distribution penalty for 5 years after the Roth conversion.