Did you realize that with a traditional 401(k) or IRA you have to pay taxes on your withdrawals once you hit retirement? This essentially means that if you have $100,000 in one of these accounts and you’re in a 22% tax bracket, only $78,000 in that account is actually yours.
There are ways you can ease the pain of that large tax bill in retirement. One way is to offset your taxes by investing in a Roth IRA. So, what is a Roth IRA and how does it work?
What is a Roth IRA?
In 1989, Senator William Roth of Delaware and Senator Bob Packwood of Oregon proposed an account originally referred to as an “IRA Plus.” This account would have allowed taxpayers to contribute $2,000 without immediate tax deductions and tax-free withdrawals once the taxpayer reached retirement age.
Then, almost a decade later, the “Roth IRA” was officially created under the Tax Payer Relief Act of 1997 and named after Senator Roth. As of 2016, almost 22 million American households owned a Roth IRA, with assets totaling about $660 billion.
How does a Roth IRA work?
You contribute to your Roth IRA with after-tax dollars. Then, once you take distributions out in retirement, they’ll be tax-free since you have already paid taxes on the contributions (this is also assuming you’ve held the account for at least five years).
This means you’re getting tax-free growth! If you use the example above of the $100,000, the entire $100,000 is yours in a Roth IRA. Pretty cool!
You’re able to contribute up to $5,500 a year to a Roth IRA (if you’re older than 50, that limit gets bumped to $6,500). However, there are there are income limitations that you need to be aware of. In order to contribute, your adjusted gross income (AGI) must be under $135,000 as a single filer and less than $199,999 if you are married and filing jointly (some “phase-out” rules also apply with these AGI thresholds).
When can you take distributions?
Unlike traditional IRAs, you can take out your Roth IRA contributions at any time. This gives Roth IRAs a bit more flexibility than other types of accounts. However, you cannot take out your earnings tax-free and penalty-free until you are older than 59 ½ and have held the account for at least five years.
Otherwise, you’re hit with a 10% penalty unless the distribution meets certain qualifications. Click here to see what distributions are tax exempt and considered qualified expenses.
Can you convert your assets?
If you’re expecting your tax bracket to be higher in retirement, something called a “Roth conversion” could potentially be an option for you since you would be “locking in” a lower tax rate now. This means you convert traditional IRA money (which was probably contributed on a pre-tax basis) to a tax-free Roth IRA; however, you’ll have to pay taxes on your conversion amount.
Make sure to do the tax calculation ahead of time before moving forward. You want to be sure you have enough money to cover your tax bill, and that the money to pay that bill isn’t coming from the account itself. Simply Money Advisors recommends working with a tax professional and a financial planner (preferably a Certified Financial Planner™) to determine if a Roth conversion is right for you and your personalized financial plan.
Can you keep your money in your account for your heirs?
With a traditional IRA, you must begin to take Required Minimum Distributions (RMDs) at 70 ½. This is not the case with a Roth IRA. You can keep all of your money in your Roth as long as you would like. This also holds true if your spouse inherits your Roth IRA after your death.
However, if your Roth IRA is passed on to a non-spousal beneficiary, he or she would have to take RMDs.
The Simply Money Point
There are many benefits to a Roth IRA. Work with a financial planner to determine if a Roth account fits into your personalized financial plan and can help you achieve your financial goals and objectives.