Why Choose a Roth IRA
By Jenn King
KEY TAKEAWAYS
Contribution limits for 2022 are $6,000 if you are under the age of 50, and $7,000 if you are 50 years or older.
The income phaseout limits for 2022 are $129,000 to $144,000 for a single filing taxpayer, and $204,000-$214,000 if you are married filing jointly.
Roth IRAs receive post-tax contributions, the money grows tax deferred, and qualified withdrawals are tax-free.
Roth IRAs offer tax diversification for your retirement years and provide flexibility to access your contributions without any taxes or penalties during your accumulation years.
You’ve been told that it is important to save for your retirement, so with your first job you started contributing to your 401k at work. This was a great option as your company had matching dollars for the dollars you contributed AND it helped to lower your income for income tax purposes. You’ve done a great job saving and are looking for other options to save for retirement. Where to save those additional dollars now?
Traditional IRA’s have been around since the early 70’s as a way to save additional dollars into retirement. However, Roth IRA’s have only been in existence for 25 years and were created by the Taxpayer Relief Act of 1997 to encourage people to save money for retirement in a more tax advantageous way. You contribute after-tax dollars – dollars already taxed via withholding on your payroll check – and then have access to those funds, both contributions and earnings, TAX FREE after age 59 ½. The Taxpayer Relief Act also opened the window to Roth Conversions which we will cover next within our blog series – Roth Strategies.
Is a Roth right for me? What are the benefits?
TAX ADVANTAGES
One of the biggest advantages of a Roth IRA is the tax-free growth and potential for tax free withdrawals.
While the dollars you contribute grow in your Roth IRA, those EARNINGS ARE NOT TAXED and when you do take distributions from your Roth IRA, you will be able to access these earnings TAX FREE. It’s important to note that your contributions can always be withdrawn from day 1, but the only way the earnings can be distributed TAX FREE is if you had the account open for at least 5 years AND you are over age 59 ½. The sooner you consistently contribute to a Roth during your accumulation years, the more tax-free dollars you will have access to in retirement.
You may also decide POST RETIREMENT to make contributions as long as you have some earned income. Why might you want to do this?
Your named beneficiaries of your Roth IRA also get to access these dollars TAX FREE. Let’s say your daughter is a doctor making a very good income and subsequently is in a high tax bracket at the time you pass away. While receiving an inheritance can be a blessing for some, a large brokerage account that must be distributed over a period of 10 years (as it is for both Traditional IRA and Roth IRAs) could really be a tax headache for that high tax bracket daughter. While she has to distribute the Roth dollars over the 10-year period, unlike distributions from a Traditional IRA (where every dollar is taxed) there will be NO TAX BURDEN for her. She will withdraw those Roth dollars TAX FREE.
Other than the obvious of not paying taxes on those earned dollars, why are these tax-free withdrawals so important?
Tax Diversification. At the time you decide to pull dollars from your retirement accounts to support the lifestyle you desire in retirement, what will your tax picture look like? Have taxes gone up and now you are in a much higher tax bracket than what you would have expected in retirement? If you have contributed to an employer plan for your working years, it is likely that you will have a large amount of your retirement dollars that will be taxed as ordinary income when you take distributions (i.e. IRA, 401k, etc). It would be nice to have multiple tax buckets from which you can draw your income from.
You may also be trying to minimize your income in retirement because you are using an ACA subsidy strategy before age 65 Medicare (see our previous blog post about ACA Subsidies) or minimize your Part B Premiums after age 65 (Part B IRMAA Surcharge blog link). Being able to pull income from a tax-free source like your Roth IRA gives you more options to keep your income minimized.
FLEXIBILITY
When it comes to accessing your saved retirement dollars, the Roth IRA can give you much more in terms of flexibility than your other retirement accounts.
Contributions – All dollars you contribute to your Roth IRA are IMMEDIATELY available for withdrawal. No penalty, no taxes. This is not the case for a Traditional IRA where every dollar withdrawn, whether it is the contribution or earnings, is taxed as ordinary income.
No Required Minimum Distributions (RMDs) – At age 72, for all qualified plans outside of a Roth IRA, you MUST take a distribution from those accounts in the year you turn age 72. Even if you don’t need those dollars, which can often be the case.
Pre 59 ½ Early Withdrawal options – While these are considered “exceptions to the age 59 ½, 10% penalty rule”, it is important to know that these options exist:
Education Funding – You can withdraw to pay for qualified education expenses for yourself or your child.
Withdrawals to help pay expenses for birth or adoption
First Time Homebuyer - up to $10,000 lifetime maximum. If you and your spouse are buying your first home, together you can pull $20,000 total from your Roth IRA’s.
Unreimbursed Medical expenses or health insurance if you are unemployed.
Important note: While you will avoid the 10% pre-59 ½ penalty in the above exceptions, you will still be required to pay taxes on these withdrawals IF the account has not been open for at least 5 years. This is commonly referred to as the 5-year rule, which we will be covering those nuances in greater detail in a later article.
If Roth IRAs are this great, how do I start? Is there a catch?
First, you need to be aware that there are CONTRIBUTION LIMITS (2022):
$6,000 if you are under age 50
$7,000 if you are older than age 50.
There’s not a catch, however, there are eligibility requirements that must be met in order to contribute to a Roth IRA. Those are:
You or your spouse needs to have EARNED INCOME. Not included are dividend/interest income, income generated from IRA distributions, etc. However, as a NON-WORKING SPOUSE, you are permitted to contribute to a Roth IRA.
Income Phaseout Limits (2022):
If you are a Single Filer, your Modified Adjusted Gross Income (MAGI) must be $129,000 to $144,000.
If you are a Married Filing Jointly Filer, your MAGI must be $204,000-$214,000.
How the Phaseout Limits work:
If your earnings are less than $129,000 (single) or $204,000 (married), then you can contribute up to the maximum contribution limit of $6,000.
If your earnings are within the phaseout ranges, then you are eligible to contribute a reduced amount.
If your earnings exceed $144,000 (single) or $214,000 (married), then you cannot contribute to a Roth.
The Roth IRA is a great tool to have as you save dollars for your retirement. The money grows tax-deferred while the money is invested. Better yet, it is a source of tax-free income when you need those dollars in retirement. All this while giving you some flexibility to access a portion of those dollars if needed before retirement.
COMING UP
Stay tuned to learn more about the power of the Roth, and the various strategies you can leverage towards building your wealth to and through retirement. Up next in our Roth Strategies series is an article that provides in-depth insights about a popular topic – Roth Conversions: When It Makes Sense and When You Should Pass.
IMPORTANT DISCLOSURE INFORMATION
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