There are many retirement savings vehicles to help you prepare for the future. Included among these vehicles are Individual Retirement Accounts (IRA) and two very well known IRAs are the Roth IRA and the traditional IRA.
A Roth IRA offers many benefits plus a great amount of flexibility with investment assets. Of course, many people want to know if they should use a Roth IRA or a traditional IRA for retirement savings. In order to answer this question, you have to understand the rules of both arrangements and consider your current income and tax situation as well as your future tax and income estimates.
#1 Roth IRA History: How Did The Roth IRA Get Started?
We can thank the late Delaware Republican Senator William Roth Jr. for helping to create what the Roth IRA is today. Roth Jr. built his political career around reducing government spending as well as improving tax cuts and was concerned about the low rate of savings among Americans.
He sought to create a more flexible version of the traditional IRA especially to encourage younger Americans to save and invest. The Roth IRA was successfully added to the Taxpayer Relief Act of 1997.
The Roth IRA has seen numerous improvements over the years, such as increases in contribution limits, the additional of ‘catch-up’ contributions, and more flexible early withdrawal options. True to Roth Jr.’s legacy, the Roth IRA provides some extremely amazing tax benefits to taxpayers.
Roth IRA Highlights And Facts
- Funded with after-tax money
- Money grows tax-free
- Qualified withdrawals (distributions) are tax-free
- Allows for flexible early withdrawals prior to age 59 ½ on contributions (rules apply, see below)
- No mandatory distributions as required in traditional IRAs
- Tax-free distributions
- No age limit on contributions, unlike a traditional IRA
#2 Who Can Contribute To A Roth IRA?
Roth IRA eligibility is limited by yearly Modified Adjusted Gross Income (MAGI) and will be affected by your tax-filing status. Only earned income can be used to fund a Roth IRA.
The IRS classifies earned income as wages obtained from working for someone or earnings derived from a personally owned business. For IRA contributions, alimony can also be used. Depending on your tax filing status as either single or married (and whether you file jointly or separately) you can contribute the maximum amount, a reduced amount, or no amount to a Roth IRA in a given year.
The IRS provides the following Roth IRA 2019 contribution table:
|Filing Status||Modified AGI||Contribution Limit|
|Married filing jointly or qualified widower||<$193,000|
> $193,000 but < $203,000
|Full contribution allowed|
|Married filing separately||< $10,000|
|Single, head of household, or married filing separately and you did not live with your spouse at any time during the year|| < $122,000|
> $122,000 but < $137,000
|Full contribution allowed|
There is no upper or lower age limitation placed on Roth IRAs. Even a minor can open a Roth IRA and contribute, provided he/she has earned income. The account owner can make contributions for as long as desired, unlike with a traditional IRA that caps contributions to a maximum age of 70 ½.
Contributions to a Roth IRA can be made even if you also have a retirement plan with your employer.
#3 Roth IRA Annual Contribution Limits
If you are eligible to make Roth IRA contributions, the 2019 contribution limits are as follows:
- If under age 50: $6,000
- If over age 50: an additional $1,000 ‘catch-up’, for a total of $7,000
If you are going to turn 50 during this calendar year (on or before December 31st), you can make ‘catch-up’ contributions. If you plan to contribute to both a Roth and a traditional IRA, the limits above are the total that you can contribute to both. For example, you can’t contribute $6,000 to each but rather $6,000 total between the two.
Reduced Roth IRA Contributions
If your MAGI only allows you for reduced Roth contribution amounts, how do you calculate your exact limit? Use the following formula:
1. Your MAGI minus one of the following:
- $193,000 for married filing jointly or widowers
- $0 for married filing separately
- $122,000 for all other individuals
2. Divide the result in by
- $15,000, OR
- $10,000 if filing a joint return, qualifying widow(er), or married filing a separate return and you lived with your spouse at any time during the year
3. Multiply the result by the maximum contribution limit
- Either $6,000 or
- $7,000 if over age 50
4. Subtract the result from step 3 from the maximum contribution limit before this reduction. The result is your reduced contribution limit.
#4 Consider A Backdoor Roth If You Are Ineligible To Make Roth Contributions
If your income is above the limits for Roth contribution eligibility and you are therefore unable to contribute any money to the Roth, you could use the very legal but somewhat complicated backdoor Roth Conversion.
In a backdoor Roth Conversion, you convert a traditional IRA to a Roth IRA. There is also an option for making after-tax contributions to a 401k, then converting.
Unlike the Roth, the Traditional IRA doesn’t limit contribution eligibility by income. Therefore, those with high modified AGIs can contribute to a traditional IRA (though it will not be tax-deductible) and later convert those assets into a Roth IRA (you will owe income tax on any growth enjoyed before converting to a Roth IRA).
Upon executing a backdoor conversion, you will:
- Pay taxes on the traditional IRA contributions which were tax-deductible (if any)
- Pay taxes on gains made while assets were in traditional IRA
- Need to wait 5 years (if under age 59 1/2 ) in order to access any account growth free of penalties or taxes (principal can always be withdrawn tax and penalty free, however)
A backdoor conversion may also increase your yearly taxable income, so you need to consider how that will affect you as well. There are also many other factors, such as timing, that will greatly affect exactly how much you will have to pay in taxes and other factors will affect when the best time to make a conversion would be.
Understand that you will need to investigate thoroughly before making any decisions and that an entirely new and lengthy article could be written on the backdoor conversion alone.
#5 Roth IRA Taxes
Let’s take a look now at how taxes are dealt with when using a Roth IRA. A Roth IRA is always funded with after-tax dollars. You don’t report Roth contributions on your yearly tax return form since Roth contributions are not tax-deductible.
Roth IRAs provide for some great tax protections. With a Roth you won’t pay taxes on:
- Dividend income
- Capital gains
- Qualified distributions (see below)
In this way, the Roth arrangement provides some great tax-shelters and benefits to the account owner and to anyone that inherits the Roth.
Accessing Your Money: When And How
There are different ways to access the money that you’ve contributed to a Roth IRA.
You need to understand the difference between a contribution, a conversion, and earnings. A contribution refers to the after-tax money that you placed into the Roth IRA account. A conversion refers to the money left over after paying taxes on the previously untaxed amount (like from a traditional IRA) and is placed into a Roth. Earnings refer to the growth made on top of the contribution/conversion as a result of the assets being invested.
You can take back any contributions (but not earnings) made at any time without having to pay taxes or the 10% early withdraw penalty. You can take Roth conversions tax and penalty free after 5 years from having made the conversion.
Keep in mind that each conversion is considered separate. Taking a withdrawal prior to the 5 year period would incur a 10% early withdrawal penalty, but not taxes. Earnings made in the Roth IRA must remain in the account until age 59 ½ and will incur a penalty if removed prior to that age unless meeting one of the exceptions below.
Some people even use a money market fund within their Roth IRA as their savings account. However, don’t lose sight of using what the Roth was intended for: saving for retirement, not as a bank to cover expenses. Your Roth IRA should be the most aggressive investment account you have for maximum long term growth UNLESS you’re using it for income now or in the near future.
If you take back a contribution (not a conversion), you don’t have to report that on your tax return form, but any earnings do have to be reported. Exceptions require additional documents in order to qualify.
To access Roth IRA assets (contribution/conversion plus earnings) tax and penalty free, you need to meet criteria for a qualified distribution (withdrawal), which include
- Distribution is made 5 years after the first Roth contribution was made and
- Distribution is made after 59 ½ years of age
- Is made to a beneficiary or estate after your death
- Is made for a qualifying exception.
Roth IRA distribution exceptions include:
- Roth IRA owner disability
- Roth owner’s death
- First-time home building or purchase (lifetime limit of $10,000) and must be used within 120 days of receiving the distribution
- Assets used for qualified higher education funding
- To pay back taxes to the IRS
- To pay unreimbursed medical expenses exceeding 7.5% of adjusted gross income
- To pay medical insurance premiums while unemployed
Distributions will be performed in the following order
- Regular contributions
- Conversions and rollovers. Earliest conversion/rollover distributed prior to more recent ones
- Earnings on contributions
If distributions are nonqualified, the 10% penalty and taxes may be applied to after the regular contributions as per the rules stated above.
Who Benefits From Having A Roth IRA?
Generally speaking younger, more aggressively invested individuals benefit from a Roth contribution over those nearing retirement who are more moderate/conservative in investment profile. Younger investors are more likely to be in a lower tax bracket as well, meaning they likely wouldn’t have saved much in current taxes with the traditional IRA, and will enjoy no taxes on the Roth IRA later in retirement.
As your tax rates rise, traditional IRA contributions become more advantageous over the Roth contributions due to the tax-deductibility afforded to you. If you expect to be in a lower tax bracket in retirement compared to your working life, a traditional IRA will benefit you because you can lower your tax bill while in the higher tax bracket, and pay taxes on distributions while in the lower tax bracket in retirement.
If you like the idea of not paying taxes on qualified distributions then a Roth IRA is a good decision. Remember, we don’t know what the tax situation will look like when you retire. Income taxes may rise in the future and this would mean paying more in taxes if you have a traditional IRA. But with a Roth, your tax commitments will have already been satisfied.
If you want to pass on your IRA investments to your children or grandchildren a Roth IRA is a good option. This is because unlike a traditional IRA, there are no mandatory minimum distributions required. So the money in your Roth can stay there for as long as you want while you’re living.
Your beneficiaries who inherit your Roth will not pay taxes on any withdrawals made. If you have these very long term goals in mind, a Roth IRA, unlike a traditional IRA, allows you to make contributions toward your Roth as long as you live. With traditional IRAs, you cannot make contributions past age 70 ½.
The Roth IRA allows for tremendous flexibility assuming that some pretty simple rules are followed, like having the Roth funds for 5 years before wanting to access them. The traditional IRA is less flexible. By establishing a Roth you can enjoy this flexibility plus the many tax advantages. Want to talk more about which investment options are best for you? Don’t hesitate to contact me. I’m here to help!