15 transformational events: The rise of the Roth IRA

Jun 23, 2013 @ 12:01 am

By Darla Mercado

The Roth IRA was just one of the provisions created in the Taxpayer Relief Act of 1997, but today it is an emerging part of retirement planning as financial advisers scour for savings on taxes.

The late Sen. William V. Roth, R-Del., was the legislative sponsor of the provision in the Taxpayer Relief Act that permits individuals to save up to a certain amount each year ($5,500 in 2013) that isn’t tax-deductible, such as a traditional individual retirement account, but that allows the income that flows out of the Roth IRA to be tax-free. His concept also paved way for the Roth 401(k) and Roth 403(b).

Conversions from a traditional IRA to a Roth IRA also were a natural byproduct of the law.

From a policy point of view, the Roth provision was a gift for retirement savers and probably not the best way to solve longer-term budget issues.

Legislation that encourages Roth conversions, for instance, harvests revenue from individuals who are paying income taxes upfront so that they can collect tax-free withdrawals later. But that just means that the government scores a windfall in the immediate term and then misses out on revenue via income taxes that would have been paid over a longer term.

“In my personal opinion, it’s bad tax policy,” said Natalie Choate, who is of counsel at Nutter McClennen & Fish LLP. “Today, government and Congress are saying, ‘We’ll take your tax now, and you’ll be exempt forever,’ but they’re just kicking the can down the road.”

PHOTO GALLERY 15 transformational events

Nevertheless, the Roth IRA is gathering steam among advisers who are searching for tax-efficient withdrawal strategies for retirees, especially now that the American Taxpayer Relief Act of 2012 has raised the highest income tax bracket to 39.6%.

The taxability of Social Security benefits, as well as the amount of Medicare premiums a client will pay, depends on a client’s level of adjusted gross income, Ms. Choate said.

“The highest tax bracket is even higher than before, so it’s more critical,” she said. “This kind of planning is just starting.”

Thomas Rowley, director of retirement business strategies at Invesco Ltd., agrees.

“From the financial adviser’s point of view, a lot of their practice over the next decade will be managing the tax liability of your retirement savings,” he said.

“A client will walk in and say, ‘Here’s my taxable money, my tax-deferred and tax-free accounts. When and how should I take out money?’” Mr. Rowley said.

“That’s a layer of planning that didn’t exist prior to the Roth IRA,” he said.

Further, Roth IRAs help protect against longevity. Although the money has to be pulled from the account once the original owner dies, the account owner isn’t forced to take required minimum distributions.

Withdrawals from that pot of money can wait until the client reaches old age, Mr. Rowley said.

Prior to the creation of the Roth IRA, advisers had fewer options when it came to creating a stream of income for clients.

“People would address tax-efficient withdrawals with permanent life insurance,” said Gavin Morrissey, vice president of wealth management at Commonwealth Financial Network. “You would look to life insurance as a tax-deferred vehicle.”

Considering the underlying cost of the insurance policy, the Roth can provide those same benefits at a lower cost, Mr. Morrissey said.

Before the Roth came along as an avenue for tax-free income, municipal bonds were a staple in the portfolios of retirees hoping to create a tax-free income stream.

These days, however, bonds are looking less attractive because interest rates are so low, Ms. Choate said.

Mr. Rowley noted that in the past, life insurance was viewed as a method of estate planning for the wealthier set.

Roth IRAs, however, were a tool for the middle class.

Beneficiaries other than the spouse have to take their distributions within five years of the death of the account holder, but they collect the money free of income taxes. Estate taxes, however, could still hit beneficiaries.

“It went from something Sen. Roth was pushing because he believed in building wealth to opportunities for financial planning that are for more than just the wealthy,” Mr. Rowley said.

“It added the spark of tax planning and self-insurance against longevity. Basically, it continued to move financial planning to the ownership society where you are responsible for your own financial planning,” Mr. Rowley said.

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