When planning for retirement, you have several options to consider when deciding which type of retirement account to fund. You may have the option of contributing to a defined contribution plan through an employer that includes a 401(k), and for those who do not have that option, an Individual Retirement Account (IRA) or Roth IRA are also good choices if you have earned income.
The traditional IRA and Roth IRA share some of the same characteristics, but there are some key differences between the two, and depending on your situation, one might be a more suitable option than the other. Here are some defining features of the Roth IRA to help shed some light on when it might be preferable to a traditional IRA:
Tax-Free Growth and Withdrawals
A major benefit of the Roth IRA is that any investment growth and earnings in the account can grow tax free. Also, distributions taken out can be tax and penalty free as long as certain conditions are met. These conditions generally include:
– There is a five-year waiting period for certain withdrawals from a Roth IRA that applies to account earnings, an IRA to Roth IRA conversion and in some instances for account beneficiaries.
– Withdrawals of earnings from the account must be taken after the account owner reaches age 59½.
There are some exceptions to these rules. In certain situations, the account holder can avoid the 10% early withdrawal penalty and the taxes if he or she is a qualified first-time homebuyer (the individual can withdraw up to $10,000), is disabled or passes away, uses the withdrawal to pay for qualified education expenses, childbirth or adoption expenses, unreimbursed medical expenses or if the distribution is made in substantially equal periodic payments.
No Deductions for Contributions
Unlike contributions to an IRA, contributions to Roth IRAs are not tax deductible. The account is funded with after-tax dollars. For individuals who enjoy the annual deduction to reduce their taxable income, the Roth IRA might not be the best option. The annual limit on contributions for a Roth IRA is $6,000 ($7,000 for individuals 50 and older) in 2021, and an individual can contribute to a Roth IRA for as long as he or she has earned income.
Early Access to Contributions
Ideally, the idea behind funding a Roth IRA is to save and grow your money for retirement. If a situation does arise where money is needed for an emergency prior to completion of the five-year rule and age 59½, contributions can generally be withdrawn from the account without incurring taxes and the 10% early withdrawal penalty. Remember, this applies to contributions only. If earnings are taken prior to age 59½ and prior to the account being open for five years, taxes and the penalty generally will apply. Keep in mind that tapping into your retirement account early can have a significant negative impact on the success of your retirement and is generally not advisable.
There are no Required Minimum Distributions (RMDs) for Roth IRAs for the original account holder. Generally, individuals are required to start taking annual RMDs from accounts such as an IRA or 401(k) once they reach age 72. These types of accounts are funded with pre-tax dollars, so the contributions and earnings are taxed at the time of the distribution. Failing to take the required annual distribution will result in a 50% penalty on the amount that was not taken. The funds in a Roth IRA are contributed on an after-tax basis, and the RMD rules do not apply to these accounts.
With a Roth IRA, funds normally subject to RMDs can remain in the account to grow tax free past age 72. This is also beneficial, because it helps the account holder prevent having to sell assets at a potentially bad time like when his or her investments are down in value. Since you will not be forced to take distributions every year, you can better avoid having to sell assets at an inopportune time.
Note that RMDs will be required for inherited Roth IRAs, though the distributions can remain tax free. A Roth IRA can be a useful tool in estate planning, but the rules can be complex, so it is advisable to speak with an estate planning expert if you decide to go this route.
There are income restrictions when contributing to a Roth IRA. In 2021, Married taxpayers filing jointly can make the full contribution if their annual modified adjusted gross income (AGI) is less than $198,000. They can make a reduced contribution if their modified AGI is $198,000 to $207,999, and they will not be able to contribute to a Roth IRA if their modified AGI is at or greater than $208,000. Single filers can make the full contribution if their modified AGI is less than $125,000, can make a reduced contribution if their modified AGI is $125,000 to $139,999 and will not be able to contribute to a Roth IRA if their modified AGI at or greater than $140,000 in 2020.
Can Benefit Younger Workers
For many people, their income increases as they progress in their careers. A Roth IRA is a good option for those individuals who expect to be in a higher tax bracket when they begin taking withdrawals. This will often include younger workers early in their careers, because they can make after-tax contributions to the account when their current tax rate could be relatively lower than in future years.
Roth IRA Conversion
There is a potential workaround for individuals who are above the income threshold but still want to contribute funds to a Roth IRA. A Roth IRA conversion allows an individual to convert certain retirement accounts, including IRAs and old 401(k)s, to a Roth IRA. There are strict rules when converting to a Roth IRA, so be sure and talk with your financial planner and tax advisor to ensure you have a clear understanding of the rules for the conversion. This will help you avoid unnecessary taxes and penalties. Taxes will be due on the conversion amount, so utilizing this tool tends to benefit individuals who believe their taxable income will be lower today than in the future.
Because a Roth IRA conversion is a taxable event, there can be significant costs in the year the conversion is made. In most instances, it is advisable to use cash from nonretirement accounts to pay these taxes, especially if the individual is younger than age 59½ and would be subject to the 10% early withdrawal penalty. One consideration is whether a conversion will generate an additional tax liability that will move the individual into a higher tax bracket. It may be prudent to complete the conversion over several years to minimize the immediate tax impact. Keep in mind the five-year rule will still apply.
Authored by Dennis Culver, Insight Wealth Strategies
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Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.