Key Points

  1. Roth IRA contributions are made with after-tax money. You don’t get a tax deduction for Roth IRA contributions as you would with a traditional IRA.
  2. The big benefit of the Roth IRA is that the money you contribute grows tax-free, and you don’t have to take required minimum distributions.
  3. Income from stock compensation can affect the contribution limits of a Roth IRA. The effect depends on the type of grant.
  4. Anyone can now convert a traditional IRA to a Roth. Income limits no longer apply.

The Rules

Before we get ahead of ourselves, let’s review the basics of a Roth IRA. Roth IRA contributions are made with after-tax money. By contrast, the standard 401(k) is pre-tax, though companies can create Roth 401(k) plans. (The American Taxpayer Relief Act of 2012 permanently expanded the provision that allows companies to permit in-plan rollovers of vested amounts into designated Roth accounts within the plan.) You don’t get a tax deduction for Roth IRA contributions as you would with a traditional IRA. Why would you make a contribution then? Because the earnings on the money in the Roth are never taxed—during your lifetime or that of your heirs. That will get almost anyone’s attention.

In addition, you don’t have to take Required Minimum Distributions (RMDs) with a Roth IRA (though you still must do so with Roth 401(k) accounts). So if you’re concerned the government could start forcing out money from your traditional IRA at the time you turn 70½, when tax rates may be higher, then paying tax up front may make sense.

Five-Year Rules

Once a contribution goes into the Roth, a five-year rule goes into effect. You have to leave the money in there for five years to get the tax-free earnings for life. You can take out your contributions at any time, tax-free, but the earnings have to meet the five-year test. If you make multiple contributions, you merely have to meet the five-year rule starting with your earliest contribution.

There is a second five-year rule that also may apply. If you do a Roth conversion (paying the tax to convert a traditional IRA to a Roth IRA), a new five-year rule applies every time you convert.

Contribution Limits

The yearly contribution limits are the same for both Roth IRAs and traditional IRAs. With Roth IRAs, you cannot contribute if your modified adjusted gross income for the year is above a certain level. In the income range just below that threshold, contribution amounts are phased out as they approach the income ceiling.

For the 2018 tax year, the contribution limits for a Roth IRA are $5,500 for a person under 50, and $6,500 for a person who is 50 or older before the end of the year. To be eligible for maximum contributions in 2018, married joint filers must have MAGI of $189,000 or less, and single filers must have MAGI of $120,000 or less. The phase-out range for partial contributions extends from there up to an income ceiling of $199,000 for married joint filers (up to $135,000 for single filers), beyond which contributions are not allowed.

You do not face any age limits on when you can contribute to a Roth IRA. If you’re still working past age 70½, you can continue to contribute to your Roth IRA, as long as your earned income is under the thresholds. Not so with a traditional IRA.

For a traditional IRA, your deductible contribution may be lowered if you participate in a 401(k). You can always make a nondeductible contribution. Since a Roth IRA contribution is never deductible, there is no reduction if you contribute to a 401(k).

Conversions From Traditional To Roth IRA

Up until 2010, if you had an adjusted gross income of $100,000 or more, you couldn’t convert to a Roth. But that’s all changed now. Starting in 2010, anyone—regardless of income levels—can convert a traditional IRA to a Roth. (For a conversion in 2010 only, you could split the taxes due over 2011 and 2012, i.e. 50% each year.) Also, all your traditional IRAs are considered in the tax calculation when you convert to a Roth. If you have after-tax assets in your traditional IRA, they are prorated in the conversion.

Once you make the decision to convert, you’ll need to identify where the money to pay the tax will come from. It shouldn’t come from the IRA. First of all, that defeats the purpose of socking away tax-free assets. Second, if you are under age 59½, you’ll pay a penalty on money withdrawn. Income from your stock grants can help pay the tax.

The big benefit of the Roth IRA is that the money you contribute grows tax-free, and the full amount of your withdrawal is tax-free. As is the case with traditional IRAs, you can’t withdraw the money from a Roth IRA until you are age 59½ without incurring a 10% early-withdrawal penalty. There are some exceptions to that—for details, see IRS Publication 590-B.

Impact of Your Stock Compensation

Any stock grant itself (or participation in an ESPP) has no impact on the annual contribution limit. However, compensation income generated from stock option exercises or restricted stock/RSU vesting can affect overall income that may limit Roth IRA contributions.

Some of the terminology used in stock option planning can be confusing. See Stock Option Basics for explanations of key terms.

The effect of stock grants on the income threshold depends on the type of grant. The spread from an Incentive Stock Option (ISO) exercise is not included in adjusted gross income (AGI). Therefore, after you exercise ISOs and hold the stock, the potential resulting alternative minimum tax income (AMTI) will not push up ordinary income or affect eligibility for Roth contributions. Should you trigger AMT, you may want to consider doing a Roth conversion up to the point where your regular income tax equals or slightly exceeds your AMT income, thus avoiding AMT tax.

But if the ISO is disqualified (e.g. by a same-day sale or a sale in the same year of exercise), the income is classified as “ordinary income” and goes into AGI.

Non-qualified stock options (NQSOs) always generate ordinary income at exercise. Restricted stock/RSUs generate ordinary income at vesting. If you want to do a Roth IRA conversion, you may choose to delay NQSO income until the next year, when possible, unless your options are about to expire.

The more income you have in the future, the more it makes sense to convert in the current year, when tax rates are potentially lower than they will be in the future. However, depending on the income bump-up from the conversion, you may trigger not only higher ordinary income tax rates but also additional Medicare tax or if over age 65, higher Medicare premiums.

Don’t forget to consider any other sources of future income, such as stock options you can still exercise after retirement or restricted stock that will keep vesting. You may also have streams of income from pensions or other retirement sources that put you into a higher tax bracket then you expected. Distributions from 401(k) plans, for example, add to your taxable income.

Alert: Consider upcoming income from stock compensation (e.g. known restricted stock/RSU vesting) in your tax and cash-flow projections when you are deciding whether to convert.

IRAs With Assets Previously In Your 401(k)

You can also convert the big-dollar IRA that resulted from a rollover of a 401(k) with a prior employer. If you haven’t yet rolled over your 401(k) plan to an IRA, the rollover rules get more complicated when you own significant amounts of company stock. Consult a tax advisor about whether you should take out the company stock using potentially favorable tax treatment, known as net unrealized appreciation (NUA), before you roll over the balance of the plan. If you convert your 401(k) directly to a Roth IRA, consult an accountant about any company stock in your plan before you convert.

Other Issues

Partial Conversions

You do not need to convert everything. You may want to run a tax projection factoring in differing levels of partial Roth conversions to see the effects on income tax. This can be especially valuable if you’ve retired early and can take advantage of “bracket planning” where you do Roth conversions before you reach age 70 ½ when required distributions must start from traditional IRAs.

Roth Conversion: Quick Check

Let’s summarize when it would or wouldn’t make sense to convert from a traditional IRA to a Roth IRA:

Reasons To Convert

  • You never have to take required minimum distributions at age 70½ or over your lifetime.
  • You can make contributions, if you have active income, past age 70½.
  • After five years and past age 59½, all distributions are tax-free for you and your heirs (though they have to take required minimum distributions).
  • You may pay less tax now if you think rates for your income level or your income will go up in the future.

Reasons Not To Convert

  • You are uncomfortable paying tax now versus later.
  • You are in a higher tax bracket than you will be in the future.
  • If you are under age 59½ and you plan to use assets from the IRA to pay the tax, you’ll have a 10% early withdrawal penalty in addition to income tax owed.
  • You don’t have available assets or cash flow to pay the tax from assets outside the IRA.
  • You don’t want the increased income on the conversion to put you into a higher bracket for Medicare or Social Security.

Combining Company Stock And Roth IRA Strategies

As if weighing a Roth conversion wasn’t already complicated enough, the complexity can explode when you add in stock option exercises or the vesting of restricted stock. There are even more issues to consider when you think about selling company stock and doing a Roth IRA conversion. Stock option exercise or sale decisions should be factored into your planning projections, as mentioned above. NQSO exercises and RSU vesting would affect current income levels, increasing your tax upon conversion. You may choose to delay stock option income if you plan on converting to a Roth IRA, unless your options are about to expire.


Case Study:

Company Stock And The Roth IRA Conversion

An executive was thinking about selling company stock and doing a Roth IRA conversion. Here are the facts.

ABC Company Stock

The executive has received stock options and restricted stock over several years. Let’s rank the order in which to sell shares.

  1. Stock options: Two vested grants.The grants include 3,200 shares with an exercise price of $24.10 and 2,800 shares with an exercise price of $27.47. These are nonqualified stock options (NQSOs), which means that she will be taxed at ordinary income rates on the spread at exercise. With a stock price of $40.82, she will have ordinary income of $90,884. Her effective tax rate (i.e. the average tax rate on all her income) is about 18%. By exercising these options, she will probably increase her effective rate to about 20% or about $18,200 in additional taxes. That rate may be lower than it will be in the future, especially when factoring in required minimum distributions from traditional IRAs. Historically, the price of ABC Company stock is near a 52-week high.
  2. Restricted stock.The cost basis for these shares is the fair value of the stock on the day the restrictions lapsed. She paid tax on the value of the stock when she received it. In this case, the cost basis is $25. With a fair market price of $40.82, the capital gains on these shares will be less than that on the shares in #3 below (about $11,500 if she sold all shares).
  3. “Older” restricted stock shares that have vested and have a low cost basis.Since the cost basis is very low, most of the sale price will be taxed as long-term capital gains. If capital gains rates increase in the future, a sale before then will save tax. If she sells all the shares, she will recognize about $1,085,700 in long-term capital gains or about $162,850 in tax at 15%.

Alert: Her strategy of when to sell the ABC Company stock is partially related to what she decides to do with Roth IRA conversions, so let’s look at that next. The income from these stock grants can also help fund the taxes owed at conversion. However, it’s also important to consider needs for diversification and funding other financial goals in addition to the conversion tax.

Roth IRA Conversions

Our executive and her husband have three retirement accounts that they can consider converting: Joe’s traditional IRA ($379,600), Joe’s SEP IRA ($137,400), and Paula’s traditional IRA ($1,495,750). Most of the amounts in the IRAs are from prior rollovers from 401(k) plans at former employers. Joe should not be actively contributing to the SEP if he wants to convert. If they converted all three, it’s about $2,012,800 in assets.

There are no non-deductible or after-tax contributions in these plans. If there were, you would need to consider pro-rata calculations when making Roth conversions. See Michael Kitces’ article for more detail on these rules.

When you convert to a Roth IRA, you pay ordinary income tax on the assets you are converting. It’s best to pay that tax with assets outside the IRA.

When you convert to a Roth IRA, you pay ordinary income tax on the assets you are converting. It’s best to pay that tax with assets outside the IRA. Many people don’t have enough in taxable assets to do that, but this couple does. If they convert everything (these are all pre-tax IRAs), the tax will be about $500,000, assuming an effective rate of 25%—if the effective rate were higher, the total tax would be higher too.

You can also do partial conversions. In that case, you would convert a portion of your IRAs to a Roth IRA. Partial conversions may make sense for many people. Also, the Medicare surtax on investment income may apply. You may want to run a tax projection factoring in differing levels of partial Roth conversions to see their effects on taxes. Some people may choose to convert just enough to avoid the next-highest marginal tax bracket or other tax impacts.

Combining The ABC Company Stock And Roth IRA Strategies

Well, as if all that weren’t complicated enough, now we want to think about combining both of these strategies. The good news is that for the most part, the Roth conversion involves ordinary income tax (the NQSO exercises would too), and the sale of most of the ABC Company stock involves the long-term capital gains tax. Our executive has a capital gains tax rate of 15%.

Alert: Although I am referencing “marginal” rates, it’s the “effective” rate that’s best to use in the Roth IRA conversion analysis (it factors in deductions and credits). For example, our executive was in the 35% marginal bracket, but her effective rate was 18.5%.

What To Consider In The Decisions

To come to a conclusion about what she should do, she needs to think about:

  • what she can afford to do
  • what she wants this money to do
  • how much risk she wants to take with her investments
  • what she thinks will happen with tax rates in the future
  • what she thinks will happen with ABC Company stock prices in the future
  • any restrictions on selling company stock
  • how she feels about paying tax sooner versus later

What can she afford to do? She can pay the tax on the conversion with the proceeds from selling her company stock.

What does she want this money to do? Well, she’s talked about buying property in Canada. The ABC Company stock proceeds could allow her to do this and give her the freedom to have two houses for a while.

How much risk does she want to take? By holding large amounts of ABC Company stock, she is taking a big risk on just one stock price. My advice has always been to try to limit company stock holdings to no more than 10% of a portfolio. When we apply that logic, our executive should sell at least 15,000 shares (using 6,000 shares from the option exercise) to get to the 10% mark.

What will happen with ABC Company stock prices in the future? The current stock price is $40.82. The 52-week high is $41.49. The stock was up 43% recently. Where is the market going? Impossible to know, but given her personal objectives she may want to sell sooner rather than later. Note that while she’s not a senior executive, she still needs to follow the company’s insider-trading policy and blackout rules to sell the stock.

With the IRA conversion, should you pay tax sooner versus later?

With the IRA conversion, should she pay tax sooner versus later? It’s hard to write a big check to the government when you don’t really have to. But she should weigh that with potentially writing even bigger checks to the government in the future.

Our executive has net capital-loss carry-forwards of about $41,000 (credits from prior investment losses). That means she could sell some (or all) of ABC Company stock and use the losses to offset part of her gains. At a stock price of about $40, she could sell 1,025 shares of the low-basis ABC Company stock and potentially not recognize a gain. Depending on the exact cost basis of the other shares from restricted stock vesting, she could sell more shares and potentially not recognize a capital gain.

Decisions

What did she do? She made a Roth conversion and we used loss carry-forwards to offset some of the capital gains tax on the sale of the low-basis company stock. She plans to take the stock proceeds and buy property in Canada. She is excited about the possibility and glad to have a more diversified portfolio.

Disclosures
The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.