Right for You?

The primary difference between traditional and Roth IRAs is the timing of income taxes. Traditional IRA contributions are potentially deductible—which means that they are funded with pre-tax dollars—but the withdrawals of contributions and earnings are taxable. In contrast, Roth IRA contributions are non-deductible—which means they are funded with post-tax dollars—but withdrawals of contributions and earnings are tax-free. Withdrawals from either type of IRA before age 59½ are generally subject to a 10% penalty. The penalty also applies to withdrawals from Roth IRAs that are less than five years old.

For most savers, the decision between a traditional and a Roth IRA depends on whether or not they are better off paying taxes now or later. If you think your tax rate will decrease in retirement, deferring taxes in a traditional IRA will result in a lower overall tax liability. However, if you expect a higher tax rate in retirement, a Roth IRA may produce greater post-tax returns.

Furthermore, with a traditional IRA you must take required minimum distributions (RMDs) beginning at age 70½, but with a Roth IRA you can leave the funds in as long as you want. If desired, you can let the funds grow tax-free for life and then pass them on to your beneficiaries tax-free. On the other hand, if your beneficiaries inherit a traditional IRA, they will be stuck with a substantial income tax bill as the account is distributed to them.

Income Limits

Traditional and Roth IRAs are subject to the same contribution limits, which are currently $5,500 per year or $6,500 if you are over 50 years old. Anyone with sufficient earned income can contribute the maximum amount to a traditional IRA, although deductions for those contributions may be reduced or eliminated depending on your income and whether or not you are eligible for a qualified retirement plan at work.

Furthermore, contributions to a Roth IRA are phased out for high income earners. For individuals, the maximum 2017 contribution is reduced when modified adjusted gross income exceeds $118,000 and eliminated when it reaches $133,000. For joint filers, the thresholds are $186,000 and $196,000, respectively.

Through the Backdoor

Income phaseouts do not necessarily need to deter you. One option is to participate in a 401(k) or other qualified retirement plan that permits Roth IRA contributions. Generally, these contributions are not subject to income limits.

Another possibility is the “backdoor” Roth IRA. Each year, you contribute the maximum amount to a nondeductible traditional IRA and then convert it to a Roth IRA. There are no income restrictions on Roth IRA conversions. You will owe taxes on the traditional IRA’s earnings, but you can minimize those taxes by completing the conversion quickly.

However, it is important to understand the pro-rata rule before choosing a backdoor Roth IRA. If you have other IRAs that hold pre-tax contributions and earnings, the taxable portion of your conversion is calculated by aggregating all of your IRAs and multiplying the converted amount by the ratio of pre-tax to post-tax assets. However, there may be a way around the pro-rata rule. If you are self-employed with a solo 401(k) or if your employer has a retirement plan that permits roll-ins, you may be able to transfer your pre-tax IRA assets into that plan.

Rules are Complex

The rules regarding Roth IRA conversions are complex. Your advisor can help you navigate them to avoid unpleasant tax surprises and achieve your retirement savings goals.

For more information, contact Jacqueline Janczewski at [email protected] or call her at 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.
© 2017

Taxing Dilemma

When an employer grants restricted stock to an employee, the stock is non-transferable and can be forfeited until it vests. Vesting is one of the terms of the stock and is generally based on years of service and achievement of performance goals.

Under Internal Revenue Code Section 83, restricted stock is not subject to tax when granted if it still has a risk of forfeiture. Rather, its value is included in gross taxable income as compensation only if the stock vests. If your stock appreciates significantly in value, you could end up with a big tax bill—at ordinary income tax rates that apply to compensation—before you get any cash to pay the tax liability. One choice is to sell the stock to raise cash for taxes. After the date that the stock vests, any additional appreciation in value is included in taxable income and treated as capital gain.

One Possible Solution

To help you avoid owing taxes that you cannot pay, Section 83(b) provides an election to be taxed at the time restricted stock is granted.

Such an election provides two important advantages:

• If you believe the stock’s value will grow, the election allows you to minimize the amount of ordinary income and pay more capital gain taxes later when the stock vests; and
• It triggers a holding period for owning the stock, so you can pay long-term capital gain rates if you sell the stock at least one year after the grant date, rather than one year after it vests.

For example, suppose that your employer grants you 100,000 shares of restricted stock valued at $0.10 per share and vesting one year after the grant date. Assume that the stock is worth $2 per share a year later when it vests and $10 per share when you sell it after one year. If you are currently in the 35% federal income tax bracket and the long-term capital gain rate is 20%, you will have some alternatives that will impact your income taxes.

Under one scenario, you do not make an 83(b) election. No tax is due when the stock is granted, but you will owe $70,000 in income taxes when it vests (100,000 shares × $2/share × 35% rate). When you sell the stock a year after it vests, you will recognize a taxable capital gain of $8 per share ($10/share minus $2/share that was already taxed) for an additional $160,000 in tax (100,000 shares × $8/share × 20% rate). Your income tax liability in the long term is $230,000.

Under a second scenario, you do file an 83(b) election when the stock is granted, paying a much smaller $3,500 in income taxes (100,000/share × $0.10/share × 35% rate) at the date of the grant. When you sell the stock two years later (one year after vesting), your entire $9.90 per share gain is treated as long-term capital gain for an additional $198,000 in tax (100,000 shares × $9.90/share × 20% rate). Your income total tax liability in the long term is $201,500.

The 83(b) election potentially results in a $28,500 tax savings. In this second scenario, you also pay only $3,500 in taxes up front, which avoids a larger tax bill when the stock vests and you have not yet received cash from the stock sale. However, there are additional tax factors that could impact the amount of tax you owe, including payroll taxes for compensation and your resident state tax, so it is important to consider the overall tax liability and the timing for the taxes that you owe.

Not Without Risk

Despite some significant benefits, an 83(b) election comes with certain economic risks. First, there is an additional risk of loss associated with owning any stock. However, with restricted stock you may have circumstances that require you to forfeit the stock, such as not meeting performance targets or leaving your job before the stock vests. If so, you may have paid tax at ordinary tax rates on stock you never received, although eventually you may have a capital loss that could have deduction limitations.

Carefully weigh your economic risks against the tax advantages if you receive restricted stock. If you want to take advantage of the Section 83(b) election, consult with your tax advisor at ORBA regarding your specific situation. The last limitation to be aware of is to file elections with the IRS within 30 days after the restricted stock is granted. It is imperative to provide a copy to your employer for valid and timely elections before tax deadlines.

For more information, contact Thomas Kosinski at [email protected], or call him at 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.
© 2017