A Roth IRA is a powerful investment tool for retirement savings. Included among the benefits of a Roth IRA are tax-free growth and tax-free distributions.
There are also no Roth IRA required minimum distributions (RMDs) when a Roth IRA owner reaches his or her required beginning date (RBD) (age 70.5, 72, 73 or 75 depending on when an individual was born) which is the case with for owners of traditional IRAs.
But the Roth IRA may not be the best choice for some individuals, and those individuals include some federal employees and retirees. This column discusses which federal employees and retirees are not eligible to contribute to a Roth IRA and the reasons why. Also presented is a discussion on which employees and retirees should not consider Roth IRA conversions, including the transfer of a traditional TSP account to a Roth IRA.
Who is Not Allowed to Contribute to a Roth IRA?
During 2023, individuals eligible to contribute to a Roth IRA may contribute a maximum of $6,500 ($7,500 for individuals 50 or older during 2023). But not all individuals are eligible to contribute to a Roth IRA during 2023. There are two reasons why an individual may not be eligible to contribute to a Roth IRA during 2023.
The reasons are:
(1) The individual’s 2023 income is too high, and
(2) The individual and, if married, the individual’s spouse, does not have earned income (salary, wages or net self-employment income) during 2023. Both of these reasons are explained.
The modified adjustment gross income (MAGI) phase-out ranges for Roth IRA contribution eligibility during 2023 are: $218,000 – $228,000 for those married filing jointly, $138,000 – $153,000 for single/head of household, and $0 -$10,000 for those married filing separately tax filers. If an individual’s MAGI is above these phase-out ranges, then an individual is prohibited from contributing to a Roth IRA.
The other reason an individual is prohibited from contributing to a Roth IRA is that the individual (and the individual’s spouse if married) does not have earned income. In order to contribute to any type of IRA (including a deductible or a nondeductible traditional IRA or a to Roth IRA), an individual or an individual’s spouse must have earned income or “compensation.”
Compensation included wages, salary, commissions, and other dollars received for personal services. Items that do not qualify as compensation include pension and annuity income, TSP withdrawals, Social Security, CSRS and FERS annuity payments, interest, dividends, and capital gains income.
“Backdoor” Roth IRA conversions (in which an individual contributes to a nondeductible traditional IRA and then immediately converts that contribution to a Roth IRA) can be a way around the MAGI limits on Roth IRA contributions. This is because there are no MAGI limits when contributing to a nondeductible traditional IRA.
However, the “backdoor” Roth IRA conversion strategy will only work if an individual or the individual’s spouse has earned income. Without any earned income, an individual cannot contribute to a nondeductible traditional IRA.
If an individual makes an ineligible contribution to a Roth IRA, either because the individual had a MAGI that exceeded the annual limit or because the individual had no earned income during the year, then the individual could be subject to a 6 percent “excess” contribution IRS penalty. Note that Roth IRA contributions are not reported on a federal income tax return.
One consequence of not reporting Roth IRA contributions on a federal income tax return is untracked contributions, allowing the “excess” contributions to accrue for many years. A 6 percent excess contribution applies for each year the “excess” contribution remains in the Roth IRA. Individuals have been eligible to make Roth IRA contributions for 25 years since 1998. With the 6 percent penalty compounding over the years, the result is that individuals who made “excess” Roth IRA contributions over the years could be subject to thousands of dollars of IRS penalties.
What Are Some Reasons for Not Converting a Traditional IRA to a Roth IRA?
Unlike Roth IRA contributions, there are no income and “earned income” limitations when it comes to Roth IRA conversions. The only requirement to perform a Roth IRA conversion is for an individual to own a traditional IRA, a SEP IRA, or a SIMPLE IRA.
But federal (and state) income taxes must be paid in the year a traditional IRA is converted to a Roth IRA. Federal retirees have the option to request a direct rollover (tax-free) a portion of their traditional TSP account to a “rollover” traditional IRA. The “rollover” traditional TSP can then be converted to a Roth IRA, with federal and state income taxes paid when “rollover” IRA is converted to a Roth IRA.
Two important points are made with respect to a Roth IRA conversion. First, a Roth IRA conversion can no longer be “recharacterized” (the conversion cannot be “undone,” which was allowed before January 1, 2019).
First, if a traditional IRA owner performs a Roth conversion and then has doubts about being able to pay the taxes due on the conversion, then there is no reversing the conversion transaction.
Second, a Roth IRA conversion is not the right move for any individual who is not 100 percent certain that they will have sufficient “liquid” funds to pay the federal, and state, income taxes that are due on the Roth IRA conversion.
Those federal employees and retirees who are certain that they have insufficient liquid assets (such as a passbook savings account or a money market fund) to pay the federal and state income taxes due resulting from a Roth IRA conversion should not convert.
There are other reasons why some federal employees and retirees may not want to perform Roth IRA conversions.
Federal Employees and Retirees with Immediate Financial Needs
A Roth IRA conversion may not be a wise financial move for a federal employee or retiree with immediate financial needs and therefore needs additional liquid assets to help pay for their daily living needs.
For example, an employee who is buying a house and needs liquid assets for the down payment and closing costs. Another example: Employees with children in college. These employees are paying college tuition and fees, room and board and other expenses related to higher education.
Or federal retirees who need more than average liquid assets to help pay their daily living expenses such as food and utilities. With the cost-of-living and inflation dramatically increasing over the last few years, retirees are especially affected with their cost-of-living adjustments (COLAs) not keeping pace with rising inflation.
Possible Exposure to “Stealth” Taxes and Increased Medicare Part B Monthly Premiums
The conversion of a traditional IRA to a Roth IRA will result in increased gross income in the year of conversion. The result is not only an increase in taxable income for the year of conversion, but also an increase overall taxes; a result of the individual possibly being subject to “stealth” taxes.
These “stealth” taxes include the additional (0.9 percent) Medicare Part A payroll tax and the Net Investment Income Tax (NIIT) of 3.8 percent. The increase in gross income for the year may also result in lost federal tax credits and deductions.
For federal retirees over age 65 and enrolled in Medicare Part B, the additional gross income resulting from a Roth IRA conversion can result in increased Medicare Part B monthly premiums. The Medicare Income Related Monthly Adjustment Amount (IRMAA) surcharges for Medicare Part B have a two-year lookback period. That means Roth IRA conversions performed at age 63 or later can increase IRMAA charges.
Employees Applying for College Financial Aid
For those employees who have children who are or who will be attending college in the near future and who are seeking financial aid, the employee’s owning any type of an IRA will not affect their children’s chances for receiving financial aid.
But a Roth IRA conversion – and with it the resulting additional gross income in the year of conversion – has to be reported on financial aid application form, including the FAFSA and the CSS Profile. The additional income could reduce – perhaps eliminate – an employee’s chances for college financial aid.
Federal Employees and Retirees Could Miss Out on Future Tax Breaks
Those federal employees and retirees who perform Roth IRA conversions now by converting before-taxed traditional IRAs and paying taxes now could lose out on significant tax breaks in the future. Two examples of these future tax breaks are:
(1) Qualified Charitable Distribution; and
(2) Medical expense deductions.
More than 90 percent of retirees do not get a tax deduction from charitable contributions because they do not itemize on their federal income tax returns. They instead take the standard deduction in which they do not get any income tax deduction for charitable donations. But by using a Qualified Charitable Distribution (QCD), an individual age 70.5 or older who takes the standard deduction can still receive a tax break for charitable donations. A QCD is made directly from a traditional IRA to a charity on behalf of the traditional IRA owner.
While there is no charitable tax deduction, the QCD is not included in the IRA owner’s income. Additionally, if the IRA owner has reached his or her required beginning date (at which time he or she must take required minimum distributions (RMDs) each year), the QCD counts toward the annual RMD. However, if the traditional IRA owner converts all of his or her traditional IRAs to Roth IRAs, then the opportunity to use a QCD is lost. This is because QCDs can only be made from a before-taxed traditional IRA.
If an employee or a retiree later in life has significant medical expenses, such as entering a nursing home or paying for home health care 24 hours a day care, and if the only funds available are Roth IRAs, then there is no tax deduction available for medical expenses.
This is because only traditional IRA distributions (which are included in income) and used to pay medical expenses can be deducted as a medical expense. It therefore makes sense for individuals to leave some traditional IRAs as they are (not converting them to a Roth IRA) to use as a possible medical deduction when withdrawn.
Traditional IRA Owners Who are Using Charities as Their Beneficiaries
Those employees and retirees who convert their traditional IRAs to Roth IRAs and who name individuals (including immediate family member, other relatives or friends) as Roth IRA beneficiaries have in effect given their beneficiaries a tax-free gift.
In many situations, traditional IRA owners have converted their traditional IRAs to relieve their beneficiaries in high tax brackets of paying the taxes due on withdrawing from their inherited traditional IRAs. Converting traditional IRAs to Roth IRAs in these situations when the IRA beneficiary is an individual can make a lot of sense.
But when the intended IRA beneficiary is a qualified charity, the situation is entirely different. A qualified charity in general is not subject to federal income taxes. It therefore makes no sense for a traditional IRA owner to convert a traditional IRA to Roth IRA, paying full income tax on the conversion when the intended beneficiary of the Roth IRA. This is because the qualified charity will not pay income tax on the IRA withdrawal whether the IRA is a traditional IRA or a Roth IRA.
Federal Employees are Encouraged to Contribute More to the Roth TSP
Federal employees, especially those employees who are not eligible to contribute to a Roth IRA because their income is too high, are advised to contribute more to the Roth TSP rather than to the traditional TSP. They should contribute each year to the Roth TSP at least the equivalent of what they can contribute to a Roth IRA. For example, during 2023 they should contribute the maximum amount of $6,500 ($7,500 if 50 or older) to the Roth TSP.
There are several reasons why contributing to the Roth TSP makes sense for these employees.
First, the Roth TSP, unlike a Roth IRA, has no income limitations for contribution purposes.
Second, upon retiring from federal service, a federal employee can make a tax-free transfer of his or her entire Roth TSP account to a Roth IRA.
Third, if a retired employee decides to not transfer his or her Roth TSP account to a Roth IRA, then as a result of the passage of SECURE Act 2.0, effective January 1, 2024 the Roth TSP account balance will not be included in the calculation of a federal annuitant’s TSP required minimum distribution (RMD). This will allow for smaller TSP RMDs for TSP participants and less federal income tax due on TSP RMDs.
Retired TSP annuitants are advised not to request a transfer of their traditional TSP accounts to a Roth IRA. The TSP has incorrectly classified these transfers as “rollovers” which they are not.
For those retired TSP annuitant who have in the past have made transfers of their traditional TSP accounts to Roth IRAs should be aware that their rollover Roth IRAs are in fact not Roth IRAs. The rollover IRAs are traditional rollover IRAs because they were funded with before-taxed traditional TSP funds. They should talk to a tax professional in order to take the necessary action to convert the rollover traditional IRAs to rollover Roth IRAs.
