Saving for retirement is an important element to every personal finance plan. But, knowing the options and which ones to take are complicated. One option to consider is a Roth IRA. Roth IRAs have many features that can make them appealing to a wide variety of savers. Here, I will explain what a Roth IRA is and how you might use it in your personal finance plan. Even if your income is high or you’re contributing at work, you may find a way to contribute to a Roth IRA. Their features are great, so read on before you decide.
What is a Roth IRA?
A Roth IRA is a special type of IRA (individual retirement arrangement). Its name comes from the U.S. senator who originally sponsored the legislation that established this type of IRA, William Roth. Roth IRAs have been around now for quite a long time. The first ones were allowed starting in 1997.
How is a Roth IRA different from a traditional IRA?
While there are similarities with a traditional IRA, a Roth IRA generally works differently than a traditional IRA. A contribution into traditional IRA normally means that you get a tax deduction for the amount contributed. Then, when you later take a distribution, the distribution is income to you. That income is then taxable.
A Roth IRA basically works the opposite. Contributions into Roth IRAs are not deductible, but if you follow the rules, all amounts coming out of the Roth are tax-free. That includes the income earned. And that is a major benefit to a Roth IRA.
What are the important features of a Roth IRA?
The tax-free income feature is a very important element to a Roth IRA. But, these arrangements have other characteristics that can make them even more appealing.
- Contributions can continue past age 70 ½: Contributions into traditional IRAs must stop once you reach age 70 ½. That is the time that required minimum distributions (RMDs) have to start from most retirement plans. But, that is not the case with Roth IRAs. Contributions can continue as long as you meet the income requirements (relating to income level and taxable compensation, see below).
- No RMDs related to Roth IRAs: There are no RMDs for Roth IRAs. This means that you can leave the contributed amounts in the Roth IRA for your whole life, if you so choose.
- No income in respect of decedent: Since the contributions into the Roth were not tax-deductible and the income is tax-free, there is no “income in respect of decedent” (IRD) when you die. This means that heirs and beneficiaries do not get surprised by having income tax to pay on an inherited IRA.
- Some early distributions are not subject to excise tax: Normally, if you distribute money from a Roth IRA prior to the distributions being “qualified,” there is a 10% excise tax penalty due for the income portion of such distributions. However, if the distributions fit into one of the following exceptions, then they are not subject to the penalty tax:
- You have become totally and permanently disabled
- You use the money from the distribution to buy a first home
- You have unreimbursed medical expenses that are more than 10% of your adjusted gross income (AGI) for the year
- You are paying medical insurance premiums while you are unemployed.
- Distributions of your regular contributions are not taxable: If you make contributions into a Roth IRA but need to pull them out later for some reason, those contributions (but not necessarily the earnings) are not subject to tax.
How do I contribute to a Roth IRA?
Here are the steps to contributing to a Roth IRA:
- You must have “taxable compensation” (earned income plus certain other types of payments).
- Your “modified AGI” must be below a certain limit ($194,000 for married filing jointly).
- Follow the contributions limits based on your age. If you are under age 50, you can contribute up to $5,500. If you are 50 or older, you can contribute up to $6,500.
- Finally, make sure that the account or other arrangement is designated as a Roth at the time that it is opened.
What if I am a high-income earner?
Even if you are a high-income earner and would otherwise be barred from contributing, there is a process called a “back-door Roth IRA” that may be something you can use. Here it is, in a nutshell. You must meet the requirements other than the modified AGI limitation. You first deposit your contribution into a regular IRA but do not take a deduction for doing so. Then, before the time limits expire for contributing for the year, you convert the regular IRA to a Roth IRA.
Other things to consider.
A Roth IRA can be a powerful tool for you to use in building tax-free retirement income. Understanding and following the rules is important. But if you do that, you can build an asset that gives you flexibility in both saving and spending.
The information contained in this article is not intended to be tax advice. Because of that, it should not be understood as “written advice concerning one or more Federal tax matters.” It should not be subject to Department of the Treasury Circular 230 section 10.37 regarding requirements for written advice. The content is for general information purposes only. Also note that tax laws do change so it important to check with your tax adviser when considering the issues in this article.