The Roth IRA changed the retirement savings landscape when it was established in the Taxpayer Relief Act of 1997 becoming a fixture in many retirement income strategies. This analysis offers a closer look at the trade-off you make when you contribute to a Roth IRA versus other types of investment accounts.
When compared to a traditional IRA, the major trade-off of contributing to a Roth IRA means you do not make a tax-deductible contribution that year (assuming you’re in a position to make tax-deductible IRA contributions). Instead, you contribute with after-tax or “take home” money. However, the investments grow tax-deferred in the same way. Meaning, if the account grows 7.5% in a year, you don’t have to pay taxes on any of the growth and thus it compounds into next year, the year after, etc. If you feel a Roth IRA is too restrictive when compared to a regular investment account, read-on, you may be surprised.
In 2018, like 2017, the Roth IRA contribution limit is $5,500, with an additional $1,000 “catch-up” contribution allowed for those 50 and older. (That $5,500 limit applies across all your IRAs, incidentally, should you happen to own more than one.) You can contribute to a Roth IRA so long as you have earned income of at least as much as you plan to contribute but no more than the income limits, which change from year to year.
Also, Roth IRAs do not have Required Minimum Distributions. As a result, unlike a traditional IRA, you can continue to add to a Roth at any age (so long as you earn income) and are never forced to take withdrawals. When you pass away, your heirs will have to take an annual distribution, however, they will be tax-free for them, just as the withdrawals are tax-free for you!
You can also make contributions for a previous year up until the tax filing deadline. In other words, the deadline for a 2017 Roth IRA contribution is April 17, 2018. One important point which is often forgotten is that the tax filing deadline is a hard deadline to make Roth IRA contributions. If you are accustomed to filing an extension and doing your taxes by October, you still need to make contributions by April 17th (or April 15th as usual).
There are pros and cons to making your contributions early in the year or waiting until the next year. If you are close to the income limits, then you should wait to fund your Roth IRA until you’ve gathered your W2 and other income statements early the following year. However, if you are far from those thresholds, you should go ahead and make calendar year (current) contributions early or monthly to take advantages of the market fluctuations throughout the year.
The maximum you can contribute depends on your age, income and whether you are a married or single tax filer. In 2017, contribution phase out range is between $118,000 and $133,000 (the maximum amount you can contribute depends on where your income falls in this range). The phase out range for joint filers is $186,000 – $195,000.
In 2018, those ranges increase slightly by $2000 for single filers and $3000 for married filers. It’s important to understand that your AGI is your income after retirement plan contributions. If you contribute to a 401k or 403b, those contributions reduce your income which may make you eligible to contribute to a Roth IRA. Also, if your spouse doesn’t work you could still fund a Roth IRA for him or her thereby doubling the amount of money you can add in a given year.
When it comes to taking money out of your Roth IRA, it’s important to distinguish earnings from contributions. Distributions of earnings from your Roth IRA, are tax-free as long as you are age 59½ or older and have owned the Roth IRA for at least five tax years. The IRS calls such tax-free withdrawals, qualified distributions.
Even if you can only set aside $1000 this year, you should open a Roth IRA to start that 5 year schedule. If you withdraw earnings before you turn 59 ½, they are treated as taxable income, and there may be an additional 10% early withdrawal tax penalty. There are many exceptions to this rule which determine whether you avoid the penalty, tax or both on withdrawals for medical expenses, a first-time home purchase (up to $10,000), disability or education expenses for yourself or your children.
However, if you withdraw an amount equivalent to your total Roth IRA contributions, that withdrawal is tax-free and penalty-free for any reason, even if you’re under 59 ½! If you know the rules of the Roth, you see it’s not as restrictive as you might think. If you’re interested in learning if contributing to a Roth IRA makes sense for you, please give us a call. If you’re already retired, we can discuss Roth conversion strategies instead.