by Judy Loy, RICP®, ChFC® and CEO of Nestlerode & Loy, Inc.
What is a Roth IRA?
Let’s start with what a Roth IRA is. A Roth IRA is a mirror image of a traditional IRA. Money going into a Roth does not get a tax deduction, which means if you make $21,000 a year and put $1,000 in a Roth, you do not deduct it from taxes in that year. You are still taxed on the full $21,000. As with a traditional IRA, all the investments inside the Roth are not taxed. The real advantage of a Roth comes in retirement. When you begin pulling, qualified distributions are tax-free. All the growth will never be taxed.
To put this in perspective, a traditional IRA or 401k worth $100,000, in retirement, must deal with taxes. If you are in a 15% tax bracket, money you pull from a traditional will be worth less after tax. The $100,000 is only worth $85,000.
In retirement, take the same $100,000 with a 15% tax bracket, but it’s in a Roth IRA. Here you could pull the entire $100,000 in a qualified withdrawal, not pay taxes on the distribution and still be in the 15% tax-bracket.
The contribution limits for a Roth IRA are the same for a traditional IRA. In 2019, you can put a maximum of $6,000 total into a Roth if you are under 50 years of age. Please know that you cannot put $6,000 into both types of IRAs, you must choose one or do a mix of the $6,000 into each. For example, you could put $4,000 into a traditional IRA and $2,000 in a Roth IRA for a total of $6,000. If you are over 50, you can put an additional $1,000 into a Roth for a total of $7,000.
Are you eligible to make a Roth contribution?
With a Roth, it doesn’t matter if you have a retirement plan through work. It only matters what your modified adjusted gross income (MAGI) is for the year.
The Roth Five Year Rule
All withdrawals from a Roth are completely tax-free and penalty-free if you satisfy a five-year holding period and one of the following conditions applies:
You’ve reached age 59 ½ by the time of the withdrawal
The withdrawal is made due to a qualifying disability
The withdrawal is made for first-time homebuyer expenses ($10,000 lifetime limit)
The withdrawal is made by your beneficiary or estate after your death
The five-year period is quite generous. It starts on January 1 of the tax year for which you made your first contribution. Therefore, if you made a 2014 contribution to a Roth on March 10, 2015, the five-year rule would be in effect starting January 1, 2014, meaning you could make qualified withdrawals starting January 1, 2019.
The good news with a Roth is that it is less restrictive than other retirement plans. Because the contributions go in after tax, they can be tapped before age 59 1/2. If you take a withdrawal from a Roth, the IRS says contributions come out first. Therefore, if you don’t take out more than you contributed, you don’t pay tax or penalty no matter what age.
It’s always best if you keep money in a retirement account, if you can. For investors who are hesitant to lock their money away, a Roth can be a great option given this early withdrawal option.
Which is better, a Roth or a traditional IRA?
As with most investment decisions, it depends. The biggest determining factor is your tax bracket. If you have a low tax bracket now and believe you will have a higher one in retirement, a Roth makes sense. Therefore, when people in their 20s are just starting out, their income can be low, and they have a long time until retirement, so it would make sense for them to do a Roth or make Roth contributions in their 401k, if available.
Time is an important factor in a Roth. This is because only the growth is tax-free. In retirement, the Roth is typically the last account to pull from. This is because all the growth inside the Roth is tax-free so the more growth you get, the better off you are.
This is one of the most complicated options for a Roth. Currently, anyone can convert eligible IRA assets to a Roth IRA. Of course, the same factors of whether contributing to an IRA or Roth matter when converting, time and tax bracket. There is a key problem in doing so. No matter the age, penalties do not apply in a conversion, but taxes do. If you convert a traditional IRA to a Roth IRA all the money is taxable in the year you do so. Whether you have money outside the IRA to pay these taxes can be a key factor in determining if it makes sense to convert.
A Roth IRA can be a great addition to a retirement portfolio. Check with your accountant and investment advisor to see if it might be right for you.