A Roth IRA is a tax-advantaged investment vehicle for retirement savings, much like a 401(k) or a traditional IRA, with the notable difference being that one contributes after-tax dollars to this type of account, rather than contributing pre-tax dollars like one does in a traditional 401(k) or IRA.
The Roth IRA was designed by Congress as a method to receive tax revenues on the front end of the contribution, and as a result, all money that goes into a Roth IRA, along with all the capital gains, dividends, and interest, are 100% tax-free upon distribution, provided a couple conditions are met. This creates a huge opportunity when planning for retirement!
Roth vs Traditional IRA
There are some notable differences that need to be taken into account when one is considering between contributing to a Roth IRA vs. a traditional IRA.
When someone contributes to a traditional IRA, they receive a tax deduction for the contributions they made which lowers their tax bill now. A traditional IRA then defers all the taxes on the assets, including the growth, until it is distributed in the future, at which point the taxes must be paid.
By contrast, all Roth IRA contributions are made with after-tax dollars. You do not get a deduction on your tax bill for the contribution, however, your full account balance can ultimately be withdrawn tax-free (both the principal and growth) provided all the rules are followed.
Another important difference between Roth IRAs and traditional IRAs is that Roth IRAs do not require you to take required minimum distributions (RMDs) during one’s lifetime (though they do for your heirs after your death). A traditional IRA requires that you take RMDs once you turn age 70.5, even if you don’t need the money, because the government needs the tax revenue! Thus it is an advantage to have a Roth IRA in addition to a traditional IRA so you can control your tax burden, along with the timing of your distributions.
How Much Can I Contribute to a Roth IRA?
Anyone can open a Roth IRA provided that they have earned income for the year, and their earnings are under the IRS-imposed thresholds (described below). For a person who is under 50 years old, they can contribute up to $5,500/year to a Roth IRA. If a person is 50 or older, there is an additional $1,000/year catch-up provision that allows you to contribute up to $6,500/year. These limits are the same for a traditional IRA, and any combination of contributions to both accounts is subject to the same limits.
For example, if a person under the age of 50 contributes $3,500 to their traditional IRA, they can only contribute $2,000 to their Roth IRA for that tax year, because their combined contributions cannot exceed $5,500.
Income Limitations for Roth IRAs
These contributions do come with phase-out limits, which simply means that if you make too much money, then you can be limited in the amount you can contribute. Instead of drawing a hard line at which income level can contribute they “phase it out” over an income range. If you exceed the phaseout limit, then you cannot contribute to a Roth IRA at all.
Thankfully the Roth IRA phaseout limits are relatively high, so the vast majority of Americans can contribute to a Roth IRA. If you are married and filing jointly on your tax return, and your modified adjusted gross income (MAGI) is less than $189,000, then you can contribute the full amount of $5,500 or $6,500, based on your age. But this is phased out over the next $10,000 of MAGI. If your MAGI is above $199,000 you cannot contribute to a Roth IRA. If your income lies somewhere in between, you can contribute to a Roth IRA, but not the full amount.
If you file a single tax return, and your MAGI is less than $120,000, then you can contribute the full amount ($5,500/year for those under 50 years old, and $6,500/year for those 50 and older), but you are phased out from making a contribution at $135,000.
It is important to note that MAGI is not your total earned income; MAGI is your total income, minus deductions, plus certain deductions added back. To keep this article from being a tedious lesson in US tax law, just remember that the phaseout limits are not your total income, but rather your income after certain deductions are applied.
When Can I Contribute to a Roth IRA?
You can contribute to a Roth IRA any time throughout the year and have it count for that year. In addition, you have until tax day to make a contribution to a Roth IRA, and still have it count for the previous year. For example, you have until April 17, 2018 to make your Roth IRA contribution, and still have it count for 2017.
Withdrawal Rules for Roth IRAs
When it comes time to withdraw money from your Roth IRA, there are only two rules that must be followed in order to receive your money tax-free. That being said, there are several nuances which can get tricky, so I have included a flow chart I created below to help clear up any confusion.
First, the distribution must not be taken before 5 tax years from the time the first contribution into the account occurred. Note that it is not 5 calendar years, but 5 tax years. Thus, you can open a Roth IRA and make a contribution on the last day before your income taxes are due, and have it count for the previous calendar year. For example, if I make a contribution by April 17, 2018, the due date for taxes in 2018, I can apply this contribution to 2017, thereby shortening the actual time for a qualified distribution (i.e. tax-free distribution) by one year.
The second rule for receiving a tax-free distribution from a Roth IRA is if any one of the following criteria are met: the person is 59.5 or older, the distribution is attributable to the person being disabled, for a first-time home purchase (up to $10,000), or upon death with the proceeds made to a beneficiary or estate of the owner.
If your distribution does not meet the 5 tax year requirement and one of the above-named provisions, then the distribution is considered nonqualified.
It is worthwhile to note that if you do take a nonqualified distribution, your contributions can always be withdrawn tax-free and penalty-free because these contributions were made with after-tax dollars to begin with. If your distribution is nonqualified, and it exceeds your contributions into the Roth IRA, then any money converted from a traditional IRA (if this applies) could be subject to the 10% early withdrawal penalty if it is within the 5 taxable year window. Finally, if, and only if, the distribution is nonqualified, the earnings in the account are taxable and subject to the 10% penalty.
The following flow chart will help you easily determine if your Roth IRA distribution is taxable or not:
Best Practices for Roth IRAs
A Roth IRA is an especially tremendous planning opportunity for investors who have decades-long investment time horizons, because as the money grows and compounds, there is no income tax when you take it out.
Thus it is recommended to place higher expected return assets within a Roth IRA, to hopefully capture those higher returns tax-free. One could consider investing in asset classes like small value index funds, or emerging markets index funds. Historically, these asset classes have higher expected returns which compensate investors for higher fluctuation. Although these assets classes have provided higher expected returns in the past, I am obligated to mention that past performance is not indicative of future results.
If one’s goal is to maximize the amount of money they can make tax-free, then it would be difficult to make the case for placing low return assets classes, like bonds, within a Roth IRA. As always, the success of the investments relies heavily on the behavior of the investor to not sell their positions when the inevitable market fluctuations show up.
A Roth IRA is an important retirement planning tool that allows you to turbocharge your retirement savings by deferring and eventually avoiding taxes on your investments.
As with all retirement investing decisions, the decision to contribute to a Roth IRA is best made with respect to a comprehensive retirement plan. Whether is it is more advantageous to contribute to a Roth or Traditional IRA is also a decision best made with respect to a comprehensive financial plan. So talk to a financial advisor or financial planner today to see if a Roth IRA can help you retire!