If you’re planning ahead for retirement, it’s important to consider all of your possible investment strategies. Finding appropriate long-term investments starts with being informed and understanding your options, such as a Roth IRA.
You contribute money to your Roth IRA from your earned compensation – whether you are employed or self-employed – after you pay income taxes. Then your future, qualified withdrawals are tax-free. Roth IRAs allow you to contribute up to $6,000 a year, plus an additional $1,000 catch-up contribution each year if you’re 50 or older.
Roth IRA contributions are required to be made either in cash or by check. Once you’ve made your contribution, you can choose from a variety of investment options within a Roth IRA, including stocks, bonds, certificates of deposit (CDs), mutual funds, Exchange Traded Funds (ETFs) and money market funds. Having these choices gives you the opportunity to diversify your savings with an appropriate mix to help meet your retirement objectives.
One of the main differences between a Roth IRA and a traditional IRA is the way contributions and withdrawals are taxed. Roth IRA contributions are made after-tax and future, qualified withdrawals are tax-free. Traditional IRAs are the opposite. Contributions to traditional IRA accounts may be tax-deductible, are tax-free and future withdrawals are taxed like income.
Another difference between these two types of accounts is the required withdrawal. If you have a traditional IRA, the IRS requires you to withdraw a minimum amount each year when you reach the age of 72. These are known as required minimum distributions (RMDs). A Roth IRA has no RMDs, so you can decide when you want to withdraw money. If you don’t need to make a withdrawal, your money can potentially keep growing tax-free.
In addition to enjoying tax-free, qualified withdrawals and no RMDs once you reach 72 years of age, there are additional reasons to consider a Roth IRA. There is no age requirement to open a Roth or even a Traditional IRA account. If you earn an income and pay taxes, you are eligible. You have the opportunity to contribute to both a Roth IRA and a 401(k) to keep growing your money. You also have the flexibility to contribute to a Roth IRA anytime during the year and up to your tax-filing deadline, which is traditionally April 15. Roth IRAs have no minimum contribution amount, which can help you start saving for your retirement faster. Plus, tax-free retirement income means you may not have to worry about future income tax rates. Your Roth IRA can also be inherited by your spouse and children and still maintain its same tax-free growth.
A 401(k) plan through your employer is designed to allow you to contribute a pre-tax percentage of your salary for retirement savings. If your employer provides a matching program, it can also reduce the tax burden for you and your employer. It’s important to keep in mind that your 401(k) is tied to your employer and is managed by an investment firm chosen by your employer with limited investment options.
A Roth IRA is an account you contribute to and manage. It offers you more control over how your contributions are allocated and invested. Having both a 401(k) and a Roth IRA can be an advantage by enhancing your opportunities to save more for retirement.
There are no age requirements to open a Roth IRA. If you earn a taxable income, you can open an account. In fact, if you start contributing at a younger age, you increase your earning potential once you decide to retire. You can even make contributions to your Roth IRA after you reach age 70½.
You can contribute 100% of your taxable compensation – up to the annual contribution limit. If you are age 50 or older, you can make additional catch-up contributions. Keep in mind, these limits are reduced by any amount you are contributing to a traditional IRA.
You also have the flexibility to contribute to a Roth IRA throughout the year. All contributions for a given tax year must be made by the tax-filing deadline.
If your income exceeds certain dollar amounts, your maximum Roth IRA contribution may be lower. These contribution amount limits are $6,000 for anyone age 49 years and younger or $7,000 for anyone age 50 and older. If you have more than one IRA, your total combined contributions can’t exceed these contribution limits.
It’s possible that your income may prohibit you from being able to contribute to a Roth IRA at all. This is based on your modified adjusted gross income (MAGI) determined by the Internal Revenue Service.
Review the MAGI charts to see if your income or joint income falls into Roth IRA contribution limits. If your MAGI falls in the "partial" range, a tax professional can help you determine your exact IRA contribution maximum.
You can make contributions to a Roth IRA for a non-working spouse if you are married, file a joint return and are earning a taxable salary.
In general, you’re allowed to withdraw Roth IRA contributions and earnings without being taxed or penalized. If your Roth IRA account isn't at least five years old or if you're not yet 59½, the earnings portion of any withdrawal may be subject to taxes and a 10% penalty. The five-year count starts with your first contribution to the account.
The IRS has defined two specific rules for the five-year holding period. Here are the details of these rules.
Five-Taxable-Year Holding Period:
- The First Holding Period Rule applies when determining if the five-year requirement has been met for a qualified distribution. This five-taxable-year holding period begins with the individual's taxable year for which they first make a Roth IRA contribution or, if earlier, the individual's taxable year of the first conversion. The period ends on the last day of the fifth consecutive taxable year.
- The Second Holding Period Rule is used to determine if the ten percent early withdrawal penalty applies to taxable converted amounts that are distributed within five years. This five-taxable-year holding period begins with the taxable year of each taxable conversion. The 10% early withdrawal penalty will apply to distributions of taxable converted amounts before this five-year period has been satisfied unless the distribution is made under a penalty exception as defined in IRC 72(t). In addition, nontaxable converted amounts are always tax- and penalty-free. The five-taxable-year period ends on the last day of the fifth consecutive taxable year.
The five year holding period is not restarted when the Roth IRA owner dies; however, the distribution options and the tax treatment of the distributions will be dependent on who the beneficiary or beneficiaries are.
A Roth conversion is when a traditional IRA is converted to a Roth IRA. By doing this, you can pay income taxes on some or all of your retirement assets immediately, rather than when you withdraw them in retirement.
If you do decide to convert a traditional IRA to a Roth IRA, you need to be aware that the taxes you'll owe for the conversion will most likely be based on the value of the investments in your traditional IRA at the time. Consider that whatever amount you convert may also be included as part of your taxable income in that year.
Here are some of the benefits of a Roth IRA conversion:
- Unlike a traditional IRA, you're generally not taxed when you withdraw contributions and earnings from your Roth IRA – as long as your Roth IRA is at least five years old and you're 59½ or older. If your Roth IRA is less than five years and you're not 59½ , the earnings portion of the withdrawal may be subject to taxes and a 10% penalty, unless an exception applies.
- You may pay lower taxes if your current tax rate is lower than your expected tax rate in retirement.
- You may have greater flexibility to manage your taxable income during retirement by diversifying your retirement assets by tax treatment, so you don't have to worry as much about future income tax rates.
- You will have no required minimum distributions (RMDs), allowing your assets to grow tax-deferred over a longer period.
- You may be able to create a tax-free legacy for your heirs.
Remember, if you change jobs or retire, you have several rollover options for your 401(k) account with your previous employer:
- Roll the money from your 401(k) account into a Traditional or Roth IRA
- Keep the money in the current 401(k) account
- Move the money to a new employer’s 401(k) account
- Take the money out of the 401(k) account, which could have tax implications for you