Webcast replay: Roth IRAs: Beyond the basics
October 21, 2013
Replay and transcript from a recent Vanguard webcast
Do you have questions about converting a traditional IRA to a Roth IRA or how a Roth IRA can work as part of a wealth transfer? Maybe you're trying to decide if a Roth IRA fits into your overall estate plan.
In this live video webcast aired October 9, 2013, Joel Dickson and Maria Bruno of Vanguard's Investment Strategy Group and Alisa Shin of Vanguard Asset Management Services™ offer some tips and strategies for you to consider.
Rebecca Katz: Well, good afternoon and welcome to this live Vanguard webcast. I'm Rebecca Katz and whether you're joining us from your desktop computer, your Smartphone or your tablet, we're thrilled you could be here this afternoon with us. Today, we are talking about one of our most requested topics: Roth IRAs and some sophisticated strategies you can use to better maximize their value.
So, after viewing this webcast, we hope that you'll have a better understanding of the role Roth IRAs can play in your wealth plan, how you can use Roth IRAs to benefit your heirs, and finally, strategies for using a Roth IRA to maximize your after-tax wealth. And with us today to discuss this very important topic are three Vanguard webcast veterans. First we have Alisa Shin, Maria Bruno, and Joel Dickson. Thanks for being here, you three.
Group: Thanks. Good to be here. Thank you.
Rebecca Katz: So, we have already received lots of questions on Roth IRAs. Again, it's one of our most popular topics. Over the next hour or so, we will be sure to answer a lot of those questions. We'll cover strategies for converting traditional IRAs to Roth IRAs; how a Roth IRA can work as part of a wealth transfer; and finally, how to decide whether or not a Roth IRA fits into your overall estate plan. But, even though we've received lots of great questions, you can send more questions our way, either through your computer or you can tweet them, and I can see them here on my tablet, using the hashtag #vglive. So send them on in. Before we jump into all of these great questions that we have, though, I thought maybe we could learn a little bit more about our viewing audience.
On the right side of your screen, you should see our first polling question. And for those of you who watch these webcasts regularly, you know how this goes. Our first question for you is "Have you converted any portion of a traditional IRA to a Roth IRA?" Your choices are "Yes," "No," or "No, but I might be considering it." So please respond now. If you don't see the poll, check and see if your zoom settings on your browser are set to 100%. I'll be back with those results in just a few moments. But why don't we—we have so many questions to get through, we decided to dispense with the commentary up front and just jump right in; would that be okay?
Rebecca Katz: Alright. Our first question is from Nicholas in Florence, Alabama. Thanks for the question. "If we are in upper income brackets and never plan to use all of our IRA money, is it prudent to convert to a Roth, to then be passed on as an inheritance?" So, Joel, we were going to come to you first. I owe you anyway, since I butchered your name.
Joel Dickson: Usually when we talk about the potential value of a Roth IRA conversion, first and foremost, the biggest consideration is often "what is your tax rate today versus what will the tax rate be when the proceeds are withdrawn in the future." If you think it's going to be higher in the future than where you are currently today, you might think about having more Roth IRA assets, because you're basically trading the lower tax rate today for avoidance of a higher tax rate in the future. That's kind of the basic discussion that we would have.
But if we take that a step further and think about more sophisticated or more complex interactions that can occur with Roth IRAs, the answer ultimately comes to a certain standpoint of "it depends in this case." Because if you're in a high income bracket, and you're going to stay there, and your heirs might have a lower tax rate, normally you would think, "Well, maybe a Roth IRA conversion isn't for me." However, there are some other things that might come into play in that decision.
One being, for example: at age 70½, you end up having to take required minimum distributions from a traditional IRA, in essence taking money out of the tax-preferenced vehicle. Whereas with a Roth, you don't have to take those required minimum distributions while you're alive.
A second one would be that, if you can use taxable assets to pay the conversion tax, you are in effect sheltering more assets in a tax-deferred or a tax-preferenced vehicle, which might make some sense, even if your tax rate isn't going to change.
And then finally, as we'll talk about more later, if you were to do a Roth IRA conversion and you use money from your—say—a taxable account, to pay the conversion tax, it removes that money from your total estate. And for those that might be thinking about estate planning, or might be facing estate taxes, given the size of their estate, that can be one tool among many that can help reduce the size of the overall estate.
Alisa Shin: I think I would just add one thing, from an estate planner's perspective. I think the other factor to consider is what your goals are with respect to your wealth. So, if a client is charitably inclined, it might make sense to not convert all of it but just convert a portion of it so that you can leave your traditional IRA assets to that charity. And because it's a public charity and a tax-exempt entity, when they receive the IRA at your death, they won't have to pay income tax on it.
Rebecca Katz: Lots of thinking that you have to do.
Alisa Shin: Exactly.
Rebecca Katz: We actually have the results of our poll in. Since we just talked about conversions, let's find out how much of our audience has actually converted already. We asked, "Have you converted any portion of a traditional IRA to a Roth IRA," and half of our audience says "Yes." A quarter of the audience said "No," and a quarter said they're considering it. Does that surprise anyone?
Maria Bruno: No, I mean, I'm pleasantly surprised. Since 2010 when the income limitations were lifted, we saw lots of conversions and that trend has actually had—well, we saw a big rush at the onset. We've seen a lot of conversions from a business standpoint, so it's not surprising.
Joel Dickson: That percentage that has done a conversion actually surprised me a little bit. It was a little higher than maybe I thought it would be.
Alisa Shin: I would agree, yeah. I agree.
Rebecca Katz: I do want to get to our second polling question but we actually have a clarifying question from someone in the audience who said—Joel, you mentioned, and Alisa talked a little bit about this, too, but—"using taxable assets to pay tax on your conversion." Can you explain what you meant by that?
Joel Dickson: Sure. So if you do a traditional to Roth IRA conversion, basically you are paying tax today on the value of the amount that you convert, to avoid, hopefully, tax in the future through the Roth IRA vehicle. Where, if you hold it for five years, older than 59½, you don't pay tax on the earnings, or penalty.
Rebecca Katz: So just to clarify, if you want to convert $100,000, you're paying tax on—
Joel Dickson: On $100,000. I mean, it could be a little more complicated than that. There might be non-deductible IRA assets, and so you have a basis, but you have to pay tax on the taxable amount that results from the conversion. So, that's where some of this planning will come into play, in converting and making that decision about whether today makes sense, or whether you would want to keep it for later and withdraw it and be taxed then.
Rebecca Katz: But when you were talking about using taxable assets to pay the tax bill, basically what you're saying is, don't use the money that you're converting—don't take a piece of that out to pay the tax bill. Use something in a money market or some other type of account to pay that tax.
Joel Dickson: So using the $100,000 example, maybe that conversion—if that's the amount that's taxable—maybe you would have a $25,000 tax bill, let's just say. If you were to use $25,000 of money outside of your IRAs, in essence, it's like putting that money inside the IRA because you haven't tapped the proceeds. You still have $100,000 in an IRA, but now, in the future, it's not going to be taxed whereas, if that $100,000 were still sitting in a traditional IRA, in the future it likely would be taxed.
Rebecca Katz: I think that's helpful, thank you. We do want to ask our audience a second polling question. So on your screen, on the right-hand side, you should see our second poll. And what we'd like to know: "Is a Roth IRA part of your wealth transfer plan?" "Yes," "No," or "I don't have/aren't aware of a wealth transfer plan." Please respond now; we'll have those results in just a few seconds. I have lots of questions about that myself.
We have additional questions. Lois from Pittsburgh, New York, says, "Is there any reason not to open a Roth IRA? Are there better times during the year than others, and might Roths be discontinued one day?" Maria, why don't you tackle all three parts of that?
Maria Bruno: Well, with regard to the first one, I think there's probably more benefits to a Roth than cons with it. I would say one comes to mind: if, as a taxpayer, you have a strong conviction that you'll be in a higher tax bracket later, when the monies are withdrawn—and Joel had talked about this earlier—then perhaps a traditional IRA may be beneficial in those situations. But the flexibility that the Roth affords, the tax-free growth, no lifetime RMDs, can be very attractive to both younger investors as well as people who may be in later accumulation years. I think there's probably more benefits to considering it than not.
As far as when to make the investment, certain times of year, my thought there is: the sooner you can make the contribution within the tax year the better, because you get that tax-free compounding clock ticking sooner rather than later. You can't time the market, so we don't know ahead of time what is the most optimal time to make a contribution, but the thought is, if you can get that money and that contribution in earlier in the year, you just have all the more potential for tax-free growth.
And then the third question—
Rebecca Katz: And the third question was "Could Roth go away?"
Maria Bruno: Well, we know what we know today, in terms of the tax structure. We can't make predictions of what might be, what might happen in the future, even with the way the estate plan works today and the estate taxes. Or even traditional IRAs—they could potentially change. We can't necessarily make decisions today based upon what we think could happen. The best we can do is know what the tax structure looks like today and make our decisions from there.
Rebecca Katz: We actually have a question in on Twitter, so why don't we take that one? It's from—these handles are always a little tricky—@justblase123, who asks, "If I am just starting out in the working world and cannot save much, is a Roth IRA versus a traditional IRA superior?" Thanks for that tweet. Alisa? Anyone? But you can only answer in 140 characters.
Joel Dickson: Oh, that's tough for me. I would say that, because of the key distinction of Roth versus traditional being current tax rate versus future tax rate, oftentimes younger folks, early in their careers, just entering the workforce, tend to have their best or highest earning years in front of them. In other words, they tend to be at somewhat lower tax rates. And if you're at a lower tax rate, the value of deferral of taking a deductible IRA for example—or even, quite frankly, a 401(k) contribution—although you'd want to capture matches—but the actual value of the tax benefit if, for example, you're in a 15% tax bracket, just isn't nearly as valuable as if you're in a 35% tax bracket or a 28% tax bracket.
So, one of the things that we often talk about is, often younger people, just entering the workforce—even if they can't save much—are probably better off, or should certainly consider a Roth IRA.
Rebecca Katz: We have the poll results in, so why don't we take a look at whether people are thinking about this in terms of a wealth plan, and I know that's Alisa's specialty, so we'll be talking to her about that. We asked, "Is a Roth IRA part of your wealth transfer plan?" And 41% of our viewers said "Yes." Again, a lot of people using Roth IRAs very effectively. 20% said "No," (or 19%), and 40% said "I don't have a wealth transfer plan." So there, we have our next webcast topic. But Alisa, again, any reaction to those results, or how people should be thinking about this?
Alisa Shin: It's good to hear that people are looking at their retirement planning holistically and taking that into consideration as it impacts their estate plan and their investment planning. So that's good to hear that 40% is doing that.
Rebecca Katz: Well, we have a very specific question around that from Craig, and he asks if you could "explain how Roth IRAs fit into estate planning, along with traditional IRAs and taxable investments. What are the pros and cons when it comes to thinking about your estate?"
Alisa Shin: Right. Well, Joel kind of hit on it in an earlier question, but just to reiterate and add a couple points. You know, I really think it's probably in three areas. One is, again, what your goals are with respect to your estate plan. Who do you want your assets to go to? Do you have a charitable intention? If you do, a Roth IRA might not be appropriate in your plan, or maybe even just a partial conversion may be appropriate. It's not a one-and-done deal. You don't have to do a 100% conversion. You can do partials and you can do it over time if your goals start to change.
The second one is if you have a taxable estate. If you're going to be subject either to federal estate or even state estate tax, converting it and paying the taxes from non-IRA assets effectively reduces your family's overall estate tax exposure. And that's just by way of mathematics—the nature of the estate tax, because it's a cumulative tax, and how that's calculated. Your family will almost always be better off if you convert and pay the income tax up-front.
Now you have to take other considerations into effect. You know, tax rate, your income tax rate today, your kids' potential income tax rate, or if you're going to give it to your grandchildren, what their tax rate's going to be. So there's a lot of different factors. There's no—unfortunately there's no one answer for all of our clients. You could have two clients who have the exact same net worth, same family structure, same ages, and I bet you they're going to come to different answers to that question.
Rebecca Katz: Does it change? I mean there were recent changes in estate tax, and I guess you have to keep your eye on that in case that changes too?
Alisa Shin: Exactly, exactly. And we did. We got a new law in January that gave us what I'll loosely call permanency, in the estate tax world, probably the first time in almost 12 years: we don't have a sunset provision. And right now, each individual can give up to $5.25 million free of the federal estate tax. But there still are a number of states—I want to say 13 to 14 states—that have their own state estate tax. So even though your net worth might be below that [$]5.25 [million], it's almost guaranteed that if you live in a state that has a state estate tax, you'll be subject. Because those thresholds tend to be much lower than [$]5.25 [million].
Rebecca Katz: Did you want to add something, Maria?
Maria Bruno: If I could add to it, because I think you need to think about it in terms of estate taxes as well as income taxes. We talk a lot around tax diversification on the planning side, when you're saving for retirement—tax diversification by having traditional, Roth, taxable accounts, gives you a lot of flexibility when you're withdrawing assets. Similarly with estate planning, so if you have different types of accounts, you can perhaps strategically think about beneficiary planning, wealth transfer. It just adds more to it, I think.
Alisa Shin: Absolutely.
Rebecca Katz: We have a follow-up question from Edward in Maryland—thanks, Edward— which you may have touched on already. "Given that the federal estate tax exemption has been raised to the point that fewer individuals will owe federal estate tax, plus Congress has raised income tax rates close to the highest federal estate tax, is conversion still a good option for high income individuals?"
Alisa Shin: It depends.
Joel Dickson: I think it gets back to the question that really started off this webcast in many ways, which is that, if you're solely looking at it on a tax rate basis, and it's high income now, high income in the future—it's a bit of push. But there are other aspects of the Roth that may help out, and as Alisa was saying, there may be other aspects of your wealth transfer—your giving plan—that might tilt it towards the traditional. It's really just—as much as I love doing it, but I know a lot of people don't—it's basically doing the math and trying to figure it out.
The one thing I would say, and it's to Maria's point of tax diversification: quite often, the answer is not traditional or Roth. It's kind of like that new car commercial, where and is better than or. It's traditional and Roth for a lot of people, because it allows you to have exposures to different potential outcomes from a tax standpoint, and allows you to optimize based on situations in the future around that.
Rebecca Katz: Our next question is from another Joel, in Plymouth, Minnesota, who says, "When does it make sense for retirees to convert traditional IRAs into Roth IRAs?" So Maria, you talked about whether there was a good month to do this, and how to position; is there—as you're approaching retirement or in retirement—is there better timing?
Maria Bruno: Well, if you're near retirement, you're thinking through this decision, you want to think of what your current tax bracket looks like now versus what it might be a few years from now when you're in retirement. Because you might have some flexibility, maybe to wait a few years and maybe hold off on that conversion. Or do partial conversions later, when your tax bracket may be lower. But that said, I do think some retirees think that, just because they are retired, a conversion may not make sense. And that may or may not be the case.
I think Joel had mentioned it earlier: when you think about distributions with a traditional versus a Roth, a Roth does not have lifetime RMDs. So if you do a conversion, then basically you're prepaying those income taxes today; you don't have to take lifetime RMDs and those assets then can pass to your beneficiaries. So that can be very attractive for certain retirees.
The other thing to think about is: on an annual basis, with RMDs, when you take distributions— and you take distributions from a Roth, for instance—it doesn't come into the calculation of whether or not Social Security may be taxable, whereas with regular IRA distributions it might be. So there are some benefits there that may vary between different types of retirees. But just because you're retired, does not necessarily mean that you can't take advantage of the tax-free growth and flexibility that the Roth affords.
Joel Dickson: I think Maria's point is really important from that standpoint. It's because Roth distributions do not add to adjusted gross income on your tax return—all of the things that get tied to adjustable gross income, like certain exemptions and deductions, and what programs you can do, Social Security taxation being one of them but not the only one. There are certain things that are deductible if you're under a certain income limit and so forth. All of those things can be affected by the Roth/traditional amount—even something like the Medicare tax on investment income. If you have an IRA distribution, that's adding to adjusted gross income; if you have a Roth IRA distribution, it's not adding to adjusted gross income. There are lots of nuances.
Maria Bruno: The thing I will add, though, is in the year of conversion. Because that will add additional income, so you may trigger—potentially—the Medicare surtax where you maybe wouldn't have otherwise.
Rebecca Katz: So to go back to that $100,000, that's an additional $100,000 that we'd talk about converting.
Maria Bruno: So you need to be careful in terms of—and that's maybe where a partial conversion could make sense. You need to just think about that.
Joel Dickson: I'm worried that we might confuse folks. The $100,000, while it will add to your adjusted gross income—that $100,000 isn't going to be subject to the additional 3.8% tax. It's any other passive investment income. It would trigger, potentially, tax on the passive investment income, because you go over a certain AGI. But in and of itself, that conversion amount won't be subject to it.
Rebecca Katz: We also have a tweet that's really—go ahead.
Alisa Shin: I was just going to say, I think the other thing is to think about a more simplistic front—your age. If you don't need your IRA to live on—you don't need those RMDs—you might want to consider converting before you're 70½, because once you're 70½, you're going to have to take the RMD out before you convert.
Rebecca Katz: Right.
Alisa Shin: It's a simple rule.
Rebecca Katz: That I can get my head around. A similar question—this is from Twitter, @herb2 asks—he says, "I'm 68 and retired. Should I convert my 401(k) to a Roth IRA and how is it done? Is there any difference there if it's a traditional IRA versus a 401(k)?"
Alisa Shin: I think if you're in a 401(k) now, and you don't have an option to make it into a 401(k) Roth—a Roth 401k—and you're retired, then you have the option to take your 401(k), converting it to a traditional IRA, and then considering converting the traditional IRA into a Roth IRA. It's going to be a multi-step process. But you could do it.
Joel Dickson: Yeah, I mean generally, it is—it's the same decision because you're going to get it into a traditional IRA. There are, again, nuances and tax planning that can come into play if by chance—we wouldn't normally recommend this—but if by chance, you're holding a decent amount of company stock. There are different things that you might want to do with the company stock than just putting it into a traditional IRA, but that's a very advanced 401(k) type of issue.
Rebecca Katz: Okay, great. We have another follow-up question. This is from James in Oakridge, Tennessee—thanks. "Could you explain, with an example, how to use a regular IRA for charity? And again, is there a timing issue—your age, things like that?"
Alisa Shin: So there's two ways that you could use a regular IRA for charity. One is while you're still living. In 2013—we've had it in prior years—if you are over 70½, you can do what they call a "Qualified Charitable Distribution," which is where Congress is allowing—really the IRS I guess—is allowing taxpayers to give up to $100,000 directly from their traditional IRA to a public charity. If it goes directly from the IRA to the public charity, the taxpayer doesn't have to recognize that amount on their income tax return.
That has been—unfortunately, we don't have that as a permanent provision in the law, and it tends to get renewed on an annual basis. It has not yet been renewed for 2014 but we're hopeful that at some point maybe it will be. So people should just start to pay attention.
In 2012 we didn't have it, but when the law came into effect in 2013, Congress gave us a window to have the QCD option in January be counted towards 2012. So even though 2013 might expire, stay tuned to see if you have that opportunity.
At death it's really just a question of how much you want to give to charity. If you want to give—in our example, $100,000—to your donor-advised fund or to your alma mater or what have you, you can designate on your beneficiary designation form that bequest, to that public charity or to your foundation, what have you.
I will tell you, you should pay attention as time goes on, to your account balances, because you want to make sure your IRA has enough assets to fulfill your charitable bequest that you want. So you know if you have a $100,000 IRA and you want to give $50,000, and you're taking distributions from it and all of sudden [it] goes below $25,000, you might need to adjust your plan to make sure that your charity gets the full $50,000, if that's what you want.
Sometimes it makes more sense to do as percentages, so that you don't have an issue about your IRA not being able to fulfill all of your bequests, your beneficiary designation. Percentages sometimes is certainly a preferable way to go.
Rebecca Katz: That's a great tip. Let's take another question. This one is from Robert in Zanesfield, Ohio, who says, "For an upper-level tax bracket investor, when does it make sense to convert from a Roth to a regular IRA, and explain a 'back-door' IRA." We've talked a little bit about the upper-level tax bracket issue, but what is a back-door IRA? Maria?
Maria Bruno: The back-door IRA is sometimes also likened to a contribute-and-convert strategy. In essence, for high-income earners who really make too much earned income to be able to contribute to a Roth IRA outright, there's always the option to invest in a traditional IRA. Anyone can do that, as long as you have earned income of course. The question is whether the contribution would be deductible or not. With this back-door Roth feature, what you could do is contribute to a traditional IRA and then shortly thereafter convert it to a Roth. So it's really a two-step process to get to a Roth, where you wouldn't be able to do it directly because your earned income is too high.
So it's a two-step strategy and there's a couple of things to keep in mind. One is you want to do the conversion relatively quickly after the original contribution, so that the account doesn't accumulate earnings, because if it does, then you might have a small tax burden there. So you want to consider that.
Also, if you have other IRAs that you're not converting, traditional IRAs that you're not converting, for the purpose of calculating the basis or any tax consequences—so you may not have consequences specifically on the back-door—but if you have other IRAs you're not converting, the IRS requires you to aggregate all of those IRAs and potentially, you could be triggering some taxes. So the strategy works most seamlessly if someone does not have any other traditional IRAs they're not converting.
Joel Dickson:What we have seen also is, investors will actually do conversions of traditional IRAs to make the back-door easier and to facilitate that in the future—again if it makes sense instead of—we always have to think about partial conversions or so forth. But there may be cases where it makes sense to convert all of the traditional IRA and now that back-door opportunity is available to you each year, if done for new money, without doing this.
Just so it's clear, the reason that this back door is open, is that—as Maria mentioned—there are income limits on Roth IRA contributions directly. However, there are not any income limits on doing conversions. So you might have income that doesn't qualify you for direct Roth contributions, but you can still do a conversion, and that's where this "contribute to a non-deductible traditional IRA" comes in, and then convert it.
Maria Bruno: Right, so this really wasn't a strategy prior to 2010, but now it is a strategy. We have information on vanguard.com if someone wants to go and take a look at that in terms of what the income limitations are and things like that, to help determine whether you can contribute outright or whether you need to do some type of back-door strategy.
Rebecca Katz: Our next question is from Marilyn in Trinidad, California. "If I want to leave my Roth IRA to my grandson, do I need a trust for it? How do I do this? At a previous Vanguard presentation or webcast, I think the presenter said you could not have a trust as a secondary beneficiary. Is that true?" So, Alisa, I will turn this one over to you.
Alisa Shin: The direct answer to that question is you might have given some misinformation about a trust being able to be a beneficiary of a Roth IRA. It can be. The one caveat is that if you are going to have a trust be a beneficiary of either a Roth IRA or a traditional IRA, you want to make sure that trust is very carefully drafted. You want to make sure that you're working with an attorney who specializes in estate planning, because there are very specific rules that have to be met with respect to the design of the trust to ensure that you can have the stretch-out nature of the IRA—or the Roth IRA—preserved.
Rebecca Katz: What does that mean, the stretch-out nature?
Alisa Shin: Being able to be take the RMDs, if it's a traditional IRA for instance, over the life expectancy of the beneficiary. That's really with respect to the traditional IRA. I still think you want to make sure that you have a very carefully drafted trust.
To answer the first question though, if you're giving it to a grandchild, should you have it in trust? And it depends. I seem to say that all the time. A couple of factors—one is the age of the beneficiary. Certainly if the beneficiary's a minor or is still young enough that they might be easily influenced by large amounts of money, a trust might make sense.
The other factors are if you have a beneficiary who might not be a minor but just mismanages money or is easily influenced by third parties—outside influences—who might encourage them to do different things with the money that might not be appropriate, a trust might work there.
Other factors also include the need to do what I call "generational tax planning," depending upon what the family's overall net worth is, how their assets are structured. You could certainly design a trust so that the grandchild could be the beneficiary of the trust. Any assets remaining yet in the trust at the beneficiary's death won't be subject to estate tax again. So, generational tax planning. And then lastly, creditor protection. Clients who are concerned about the beneficiary—their grandchild—being sued if they're in a high risk profession, or even if they're just simply worried about divorce in the future. A trust can provide a pretty solid layer of protection from a future creditor or divorcing spouse.
Joel Dickson: And I think it's important again to clarify one thing, which is why this becomes a very interesting planning discussion—which is, as we've talked about, how hard minimum distributions are not required for Roth IRAs during the lifetime of the owner. But once you pass away and it goes to your heirs, you are required to have distributions yearly from the IRA.
Now typically—and Alisa and Maria, correct me if I'm wrong here—typically you have to take it out at sort of the same speed that it had been taken out during your lifetime. If you had started required minimum distributions in life in a traditional IRA, doesn't it have to come out in a similar approach or can you –
Alisa Shin: It depends. Sorry.
Joel Dickson: It depends. Never mind. No, that's fine. But the point being, on the Roth IRA, there's no—there haven't been RMDs, and if you spread that over the life of a grandchild, you are going to be taking out very little each year because the life expectancy of a 4-year-old obviously is a lot longer than the life expectancy of a 70-year-old. And since that RMD is based on the average life expectancy, you'll be taking out a lot less, allowing the Roth in that case to grow tax-free for an even longer period of time.
Alisa Shin: Just to clarify what Joel said on the RMDs and my answer about "that depends" for the traditional IRA is: it depends on when the account owner died and how well the trust is drafted. If the trust is drafted correctly you will have the ability to take the RMDs based off the oldest beneficiary's life expectancy. Even if the client was 75 at their death, you can take it over at the 4-year-old's life expectancy [inaudible].
But if the trust isn't properly drafted, you might lose that, and so they'll have to withdraw it within five years or possibly over the decedent's life expectancy. There's a lot of different factors, so that's why it's really important if you're going to have a trust be the beneficiary of an IRA—whether Roth or traditional—to make sure that you're working with a estate planning attorney to put that trust together.
Rebecca Katz: Okay. Great. We've got several questions—I've got them coming in from all devices. But let's take this one from Jerry in Naples, Florida, because I think it's related. Thanks, Jerry. He says, "I have a Vanguard Charitable Trust. Can I transfer to that from my IRA without paying income tax on the amount transferred?"
Alisa Shin: It depends on the timing. So if we're talking the Q[ualified] C[haritable] D[istributions]—$100,000 during the lifetime—unfortunately right now donor-advised funds—which is what the Vanguard charitable account that he's referring to is—cannot be the recipient of a $100,000 QCD. If we're just talking about giving the IRA at death, absolutely, you just have to designate your Vanguard Charitable Account as the beneficiary of that IRA.
Rebecca Katz: Okay, great. We have a tweet in from @MissElise, who is in her early twenties and says, "What should I consider when making personal contributions to my older established Vanguard Roth versus my new employer 403(b) Roth?" So what many people may not know is that many company plans—401(k)s, 403(b)s for folks in the public sector—offer a Roth feature, so you can pick a traditional 401(k) that's tax deferred, or you can use after-tax money to fund a Roth 401(k). So what should @MissElise consider?
Maria Bruno: I would say number one is, if the employer plan offers a match—so with the IRA there is no match, there's no one matching it, so you're making your own contributions. With any type of employer-sponsored plan, you want to at least make sure you're contributing up to the match, because otherwise you're really leaving money on the table.
I would also add, then, investment options. So if you're investing in an IRA you have a lot more flexibility, potentially, than your employer plan. With a 403(b), maybe not so much, maybe there's more flexibility—depends upon the plan design.
So you want to think about what investment options are offered within the plan and whether they're restrictive or not. Because the Roth IRA would give you more flexibility. And then the only other thing I would add, before Alisa and Joel jump in, is with the Roth IRA there is some flexibility built in that may not be there with the 403(b) or 401(k). For instance, with the Roth IRA you can always pull out your contributions. Certainly it's designed for retirement and we always advocate that they use 403(b)s for retirement. The Roth does offer some features; regardless of why you need to withdraw the contributions, they can always be pulled out without tax consequences. And then there's other qualified distribution options, like for first time home purchase. So this could be something that a young investor might want to consider. You can pull up to $10,000 out without penalties, so some flexibility there. But those would be the big things I would think about.
Joel Dickson: The only thing I would add there again, from a point of clarification, that the employer match—even if you're contributing in a Roth fashion in a 403(b)—the employer match is going to be as pre-tax dollars, that when you pull it out in retirement or whenever, would be taxed at that point in time. So it's more like a traditional. So sometimes people will not fully understand that, and they'll look at their statement and they're like, "Wait, I've got this weird mix of pre-tax and after-tax." It's kind of being surprised; it's like me looking up one day and I have sweat socks I'm wearing with my suit or something. It's "Wait, I wasn't expecting that but it ended up that way." So it's just something to keep in mind.
Rebecca Katz: Well, we've talked about tax diversification.
Joel Dickson: Exactly. It's actually a benefit.
Rebecca Katz: It makes it harder to calculate when you're ready to take the money out though. Our next question goes back to the grandchildren question. Joe from West Bloomfield, Michigan, says,"Is there any drawback to designating my grandchildren as opposed to my children as Roth beneficiaries?" It sounds like we've talked about some of the advantages, if you're talking about a much longer time horizon; are there any drawbacks?
Alisa Shin: I think one factor is whether or not your children need the money. Are you disinheriting them because there's a reason that you're doing so, or you're giving other assets? Some people assume that because they might give it to the grandchildren, the grandchildren will take care of the parent if the parent really needs the money. I always think that's a little risky. One would hope, but you never know.
I would want to make sure that the grandchildren truly are the intended beneficiaries of it. And just going on the softer side of the planning, is really thinking through—depending on how old the grandkids are now—what kind of sense you have, what kind of people they are, how they manage money, how their decision making skills are. If something happens to you prematurely and they receive a Roth IRA that's a large amount, it could have negative consequences that are not intended.
So if you are considering that, I would really encourage you, if you're comfortable, to make sure that you're talking with your kids, so that you can coordinate your planning with your children's planning to ensure that everyone is on the same page and there's no surprises at the end of the day.
Rebecca Katz: Conversation—it sounds like a lot of this comes down to having conversations and being thoughtful about what your intentions really mean.
Joel Dickson: I think we can generalize that discussion even a little bit more. Which is to say, beneficiary designations generally are extremely important and can affect plans. For example, there's a lifetime unlimited spousal estate tax benefit. So if you start then going to different beneficiary designations, you might trigger estate tax if it's not a well-crafted plan. So there are lots of things to think about with beneficiary designations.
Rebecca Katz: So all of our viewers, after they're done watching us talk, should log on to vanguard.com and check and see, if they haven't looked in a while, who they have designated as beneficiaries on their accounts, right? We have a follow-up question; this is from Lee in Los Angeles, who says, "Please talk more about partial Roth conversion issues." Maria, Joel? I'll open it up to the floor.
Maria Bruno: I think partial conversions are very attractive because, to use your "and/or" example, it's not an either/or decision. Partial conversions are a great way to, one, manage your current tax bracket. So if you want to convert but you're worried about what your current tax rate looks like, and what the additional income would do, it might bump you up into a higher tax bracket, potentially trigger taxes that wouldn't otherwise have been triggered. You want to look at what happens with the amount that you're converting that year.
And then also you want to take a look at if you have other account balances, other IRAs that you're not converting. Because you do—as I mentioned earlier—you need to aggregate all traditional IRAs for the purpose of calculating the basis or what the tax liability on the partial conversion would be. So the IRS doesn't let you cherry pick which—
Rebecca Katz: Can you give me an example? What do you mean by that?
Maria Bruno: Well, I might have, for instance, a contributory IRA that I have contributed to during my working years, but also potentially a rollover IRA. So I have an employer-sponsored plan that I rolled into my IRA; that's all pre-tax dollars, so when I go to convert that or take withdrawals, it would be all fully taxable. I might have a smaller IRA that I might want to convert, and while that may seem attractive and a good opportunity because it allows that account to grow tax-free, I need to consider this large rollover IRA for the purpose of calculating the current tax liability on the conversion.
So the IRS may let you decide which one you convert. But for the purpose of calculating what the tax liability is, you need to look at all the traditional IRAs together, and what the pre-tax balance is.
Rebecca Katz: We just got this great question in that I was going to ask you myself if nobody else did. This is from George in North Carolina, so thank you, George. "Please explain Roth re-characterization." Is this the "oopsie, I converted and I shouldn't have done that"?
Maria Bruno: Yes, but it's not always an oopsie. It could be a very viable strategy that someone is employing. Actually we're having these conversations right now because at the end of last year there was a lot of uncertainty around what would happen with 2013 tax rates. So some investors actually decided they would convert, and then maybe decide to re-characterize later. So what a re-characterization is is it's really almost a mulligan; the IRS lets us do a do-over. So if you convert to a Roth IRA or even if you contribute to a Roth IRA and then decide that you want to reverse that, the IRS allows you to do that.
Now there are some stipulations; there's holding period requirements. So if you converted last year, for instance, and you want to re-characterize this year, you have until essentially October 15 to do that. So it's a tax filing deadline or a tax extension.
So you can convert them. Basically what it does is it takes whatever—whether it's a partial re-characterization or a full re-characterization—brings that back into a traditional IRA. So any earnings or losses would be carried back over into that traditional IRA. The end result is as if the conversion never happened or the Roth contribution never happened.
Joel Dickson: Where this can be valuable is, for example, although this is not as likely this year—given that we've had pretty robust financial market returns—but let's take that $100,000 that we had been talking about earlier and you converted that from a traditional to a Roth IRA. Let's assume that it was fully taxable, so it was all $100,000 of pre-tax dollars.
If the investment that you put it into in the Roth IRA were to have gone from $100,000 to $80,000, that is, declined 20%, sort of go "Well, why should I pay taxes on $100,000 when right now the account is worth $80,000?" So re-characterizing back to the traditional IRA where now you have $80,000—and then once you get over the certain requirements to then do a reconversion, which basically is either 30 days following the re-characterization or the next tax year—it sort of depends on where you are in the tax cycle. You would now just reconvert $80,000 and pay tax on $80,000, instead of paying tax on $100,000 if you wouldn't have re-characterized.
Rebecca Katz: Assuming the markets didn't go back up.
Joel Dickson: Yeah, exactly.
Maria Bruno: There's holding periods. So you're kind of at the mercy of the markets, almost, depending on how you're invested. You can actually put the monies back into the traditional IRA and keep it there or you can actually reconvert after the holding period expires.
Joel Dickson: One of the things that I do think we have to be careful about in 2013—because as Maria mentioned there was a lot of uncertainty about tax rates, we have the fiscal cliff, all that kind of stuff—for some people tax rates increased in 2013 from where they were in 2012, either through all of the deductions changing, or through the Medicare, or through ordinary income tax rates. So even if the account went down in terms of the value of the conversion from a traditional to a Roth, it might not make sense to re-characterize, because now you would be reconverting in 2013 or 2014 at potentially higher tax rates. So what matters is the total tax bill, not so much the amount in the account.
Rebecca Katz: Well, we have a question, again through Twitter, from @DonkDonk who says, "In 2013, I'll have lower income than usual. Is this a good opportunity to do a partial Roth conversion?"
Alisa Shin: I think the simple answer is probably, it's at least worthwhile to look into. It probably will be worthwhile to do the conversion at this point. Absolutely.
Rebecca Katz: A follow-up, we have another question from Elhas, who says, "I've inherited traditional IRAs in addition to Roth IRAs. Can inherited IRAs be converted to Roth, partial or all?" Can you do anything with a traditional IRA other than take out the money?
Group: No, they cannot be [converted]. Inherited IRAs cannot be.
Rebecca Katz: These are easy questions. We have another question from Charles in Houston, Texas, who says, "In retirement, should my Roth be managed? Should I continue funding it in retirement, start withdrawing before or after taxable and tax-deferred accounts?" We promised to talk about managing retirement income using a Roth. Is there a good approach here? And if he's retired, I assume he has no earned income and therefore can't contribute?
Maria Bruno: That's one assumption, yes. So you can't contribute unless you have earned income. If you're taking distributions by having the different account types, you can strategically manage that on a year-by-year basis. So the previous individual who was in a low tax bracket, for instance, may be considering a conversion. Well, if you're withdrawing and you may be in a very low tax bracket, then you typically would—for whatever reason in a particular year—then maybe you would want to draw from tax-deferred that year and not Roth.
Generally speaking, the more you can let the Roth grow tax-free, generally the better off— because that account gets to grow and you don't necessarily need to take the RMDs and what-not. But assuming that you don't have RMDs from the traditional IRA, you're usually faced with the "where do I spend from" and generally if you have taxable assets—because those are taxed at lower rates, capital gains rates are taxed lower than income tax rates, and you might have some losses and things like that you can manage in taxable accounts—that's usually the first source of spending. Beyond that, then you want to look at what your current tax rate is versus future tax rate expectations.
Joel Dickson: And tax rates can change quite a bit in retirement. I mean, think if you have large medical expenses one year. So you might have much higher itemized deductions, for example. Well, there your tax rate is a little bit lower than normally where it would be. And so there you might want to take distributions from the traditional IRA, because it won't be as heavily taxed. Whereas in other years maybe you have a higher income, and so to the extent that you need resources from a retirement income standpoint, you take it from the Roth.
Alisa Shin: This is where I risk getting kicked under the table by my investment colleagues here. From an estate planner's perspective, obviously depending upon what your overall taxable estate is, what your net worth is, if you are subject to federal or state estate tax—f you are, from an estate planner's perspective, it is generally better to leave what I'll call taxable assets, non-IRA assets, to your individual beneficiaries than it is to give a traditional IRA. Just because that IRA will be subject to both the state tax and income tax as your beneficiary takes it out, especially if your beneficiary will be in a higher tax bracket than you are currently in. It might be even more important for you to spend down from your traditional IRA.
Where I usually end up compromising with my colleagues here, which came about in 2010, was to say if you don't want to spend down your traditional IRA, at least convert that amount into a Roth IRA and we get almost the best of both worlds.
Maria Bruno: I think what we're really getting to here is that there's an interplay between income taxes and estate taxes, depending upon how large your net worth is. And if you're in that situation and you want to pass assets to your heirs or charities or whatnot, then you really probably want to sit down with a professional and talk about it. Because you do want to maximize the wealth transfer, minimize the current taxes as much as possible. But there is a big interplay between income taxes and estate taxes.
Joel Dickson: There's just big interplays all over the place here. I actually worry we've given the impression that in the year of Roth conversion, you're always going to have induced even higher taxes. Yes, you have to pay the tax on the conversion. We talked about deductions and exemptions and so forth. But even there, there are actually potential offsets, because if you have more income you might have less alternative minimum tax. So you might not be paying the full freight of the marginal income tax rate.
Or it might raise your charitable deduction cap. Because you have more AGI, adjusted gross income, you can actually give more to charity if you're a big charitable giver in those years. So one strategy is actually to pair large charitable giving with Roth IRA conversions. So there are lots and lots of nuances to this.
Rebecca Katz: Sounds like you need both the estate planning attorney and a good accountant. So here's something entirely different. Diane asks if a Roth IRA is a good investment option for a child's college education, or is there a better choice. Well, I guess we don't know if the child has earned income or not. I'm not clear whether she's investing in a Roth for herself, to use for college, or putting money away in her child's account.
Maria Bruno: Well, we can probably talk about it broadly. So usually the most viable college planning option is the 529 college savings plan, for instance. So if you look at that versus a Roth IRA, you potentially could use a Roth IRA to fund the college expenses. It may not be optimal. There's two things, in my mind, to think about. One would be, as I had mentioned earlier, you can always pull out the contributions from the Roth IRA regardless of the reason, without paying any type of penalties or income taxes. Beyond that, to the extent that you dip into any type of earnings, you could potentially be triggering income taxes or penalties. Penalties if you're under age 59½ and have held the account for less than five years, for instance. If you're taking a withdrawal and making it directly payable to a higher education institution, then you may not be subject to penalties on the withdrawal. But certainly income taxes may come into play, to the extent that you're withdrawing any type of earnings. So keep that in mind, because you could be triggering income taxes that you may not have thought about.
The other thing that I would mention is financial aid considerations. So with the Roth IRA, even though it's not necessarily considered an asset of the child or the parent for the purposes of calculating the financial aid formula, withdrawals would be considered income regardless of whether or not you pay any income taxes on it. So you need to think about the federal aid considerations, I think, and also if there's any income taxes triggered. It might be viable. It's probably not the best option, but an option to consider.
Joel Dickson: Actually, on a very simple level there's a caveat to it. At a very simple level, a 529 college savings plan is kind of a Roth IRA for college savings, in that you contribute after-tax dollars, and if the withdrawals are for qualified educational expenses, there is no tax due on the earnings in the account. Now, there are different rules that obviously apply around when that money has to be used, how it's transferred between different beneficiaries or account owners and so forth, but the tax situation is pretty much the same between that.
Rebecca Katz: Except that you can get tax benefits from contributing to a 529 plan.
Joel Dickson: You can in some states; in some states it's deductible.
Maria Bruno: If you're making future contributions for college funding, then a 529 is probably more optimal. But if you're in a situation where you have to pay college bills and you have these resources, then at that point you want to look at "what are the tax ramifications of this." So certainly if you're making contributions the 529 is probably the way to go.
Alisa Shin: One caveat I would say: again, if you have a net worth that is even going to subject you to state estate tax, where the threshold is lower than the $5.25 million federal estate tax threshold, clients might want to consider making payments of at least the tuition directly to the school from their taxable money, because that's the one nice exception that the IRS has given to us from the gift tax. As long as those tuition payments are made payable directly to the school, the IRS does not consider that to be a gift.
The client might consider that to be a gift, but the IRS does not, and there is no ceiling on that. That amount does not offset the client's ability to give the annual exclusion gifts—the $14,000 a year—and it doesn't impact their $5.25 million dollar lifetime exemption. So it's a very tax-effective, tax-efficient way to reduce your estate tax exposure and help your family out at the same time.
Rebecca Katz: We only have a few minutes left, so why don't we try to motor through some of these questions. Leonard from Lafayette, California, says, "Is there an optimum balance between a Roth and traditional IRAs?" We talked about the diversification—is it 50-50, 75-25? Is there anything that we have in mind that gives you maximum flexibility?
Joel Dickson: It's going to depend on individual circumstances, sorry. But let me explain how. Something like the 25% tax bracket is a pretty wide tax bracket. So if we think about, in retirement, that you'll have lower income, lower income doesn't necessarily mean a lower tax rate. So if you are earning at the higher end of the 25% tax bracket, you might still be in the 25% tax bracket in retirement. If you're at the lower end of the 25% tax bracket, you might be at the 15% tax bracket in retirement.
So your mix of having Roth and traditional, even for people that are in the same tax bracket today, might be very different. The person that is reasonably certain that they're going to see a tax rate lower in retirement than today is going to want to have more traditional IRA assets than somebody who isn't nearly as certain that their tax rate is going to change materially.
Rebecca Katz: We have a similar question, kind of looking for a rule of thumb, and I think the answer's going to be similar. Michael from Minneapolis asks if there's a crossover point at which it's better to invest in a traditional IRA compared with the Roth. So is there some magic number, magic tax rate where you're better off doing the traditional or the Roth? Or is the rule of thumb just younger versus older, or is it "it depends"?
Alisa Shin: It depends; there's a lot of factors. Where the crossover point is really depends, in the estate planning world, [on] who your ultimate beneficiary is. It's not necessarily the account owner who's doing the conversion that's going to be able to feel benefit from that prepayment of the tax; it really could likely be your beneficiary where that crossover point happens. I don't know what you guys think.
Maria Bruno: One of the easier client profiles would be younger investors. We talked about that; that's an easy one, where if you're making contributions you can contribute to a Roth 401(k) for instance, and the employer match goes into the traditional 401(k), so right off the bat there you have tax diversification. And as Joel had mentioned, as you're early in your working career, your earnings potential is only going to grow, so the value of the tax deduction isn't as valuable as it would be later. So I think that's an easy situation to evaluate. From there, as you start to get maybe more into your advanced working years or closer to retirement, that becomes more of a case-by-case situation, I think, and looking at what your earnings are versus what they might be in retirement. It is tough, because as Joel had mentioned you don't know what the future tax rates are going to be, let alone what the brackets are going to be.
That's why having the diversification—having some is better than none. And having more is better than having some, I would think, in terms of having different buckets.
Rebecca Katz: I like that; that's a nice way to leave it. Having some is better than none. And "it depends." Well, this has been great. Obviously a lot for our viewers to think about, for me to think about, lots of considerations. I know there's more information on our web site available if people have additional questions. So I just want to say thanks to all three of you for being here.
And thanks to all of you for watching and sharing a part of your afternoon with us today. We know we covered a lot of ground, so we will be sending out highlights of this video of the transcript to you in just a few weeks. Again, check out vanguard.com for more information. And if you'd like, join us on Vanguard's Facebook page if you have additional questions we didn't get to. We'd be happy to entertain a few more questions and give you some answers from our three experts here.
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So once again from all of us here at Vanguard to all of you, thanks so much for watching and we will see you next time.
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