April 2019: To Roth or Not To Roth
To Roth, or not to Roth, that is the question. Who would have thought that Shakespeare would be so educated on 21st Century savings techniques? In all seriousness, many of us have heard of Roth IRAs and their potential benefits, but exactly how do these accounts function and when are they best suited for your use? This month’s newsletter will discuss the basics of Roth IRAs, who can and should contribute to them, and the IRS rules applied to Roths. For starters, Roth is short for Roth Individual Retirement Account (Roth IRA). Roth IRAs are retirement accounts that give you the ability to save and grow after-tax funds tax-free. Meaning, funds that have been taxed are contributed to a Roth IRA which then grows tax-free, and are tax-free upon withdrawal, assuming that you meet the IRS withdrawal requirements. More detail on this below. The best feature of a Roth is that none of the gains or income accumulated within the account are taxed, neither are the gains when they are withdrawn from the account. As you may imagine, these accounts can be extremely powerful tools for retirement funding. So, should you contribute to a Roth? First, does your current employer offer a retirement plan? If your employer does have a retirement plan, consider contributing to this account. If they offer a match, then it’s even better. We typically recommend that people should first contribute to their employer’s plans to get the company match, or “free money”. If you have contributed to your employer’s plan, possibly received the match, and still have funds available for your retirement account(s), it is at this point that we would recommend you consider contributing money to a Roth IRA. If your employer does not have a retirement option or you work by yourself, consider contributing to a Roth IRA instead of a Traditional IRA account. Individuals can contribute up to $6,000 a year if under the age of 50 and $7,000 a year for those over the age of 50. Now that you’re considering contributing to a Roth, you must find out if you qualify to contribute to a Roth, as the IRS has a few rules associated with Roth IRAs. The restrictions on who qualifies to contribute to Roth IRAs (set by the IRS) are primarily based on the potential participant(s)' adjusted gross income (AGI). The IRS sets income limits on who is allowed to contribute to a Roth, depending upon marital status, household’s employment, and total income within your household. The income level limits based upon your household can be found here. The IRS requires Roth IRA participants to have earned income, but the IRS does not have age limitations on Roth participants, like other retirement accounts. This is discussed more below. As mentioned above, there are some rules associated with Roth IRAs. Contributions to a Roth are not tax deductible and distributions from a Roth are tax-free, so long as you satisfy the requirements the IRS lists here. This differs significantly from retirement accounts such as 401(k)s, 403(b)s, Traditional-IRA, also known as tax-deferred accounts. Tax-deferred accounts are retirement accounts where you contribute pre-tax dollars thereby reducing your current taxable income and defer the potential income tax. When a tax-deferred account owner withdraws from their tax-deferred retirement account, their entire distribution is taxed at the account owner’s ordinary income tax-rate at the time of the withdrawal. As mentioned above, tax-deferred accounts have age oriented IRS rules that do not allow account owners over the age of 70 ½ to contribute to their accounts and the rules require the account owners to take annual distributions after the age of 70 ½ , known as Required Minimum Distributions (RMDs). Roth IRAs have no age limit for contributors and do not require their account owners to take RMDs after they turn 70 ½. After reading all of these rules, who are Roth IRAs best suited for? Generally, they are best for investors in lower tax brackets, due to the fact that Roths are funded with after tax dollars. Individuals in the top income tax bracket may lose up to 40% of their income to taxes, thereby foregoing almost a third of what could have been invested in a Roth. With that logic, a Roth naturally favors people in lower income tax brackets, because more of their after-tax funds can be invested. Roths are especially great tools for investors who are currently in lower income tax brackets, but anticipate being in higher income tax brackets later in life. One would effectively take advantage of their better after-tax income now, to grow their funds tax-free which will then be withdrawn tax-free at a time when they may be in a higher tax bracket. As I stated above, Roth IRAs can be very powerful and lucrative retirement saving vehicles. However, they also come with a list of rules and stipulations. If you have any questions concerning Roth IRAs please contact us.