What is a Roth IRA? A Roth IRA is one of the many individual retirement accounts available that allows you to save for the future. While most retirement accounts are tax-deferred, meaning the money goes into savings before income taxes are calculated and you pay taxes on it when you take the money out, a Roth IRA is post-tax. You don’t get a break when you deposit the money, but you don’t have to pay taxes on it when you withdraw the money.
A Little History
The Roth IRA was established in 1997 and is named after Delaware senator William Roth. While the Traditional IRA was established in 1975 and the 401k allowed in 1978, the Roth IRA is a newer vehicle; the rules for this vehicle are a bit more changeable.
How Does a Roth IRA Work?
Your Roth IRA can be purchased from a broker or a robo-advisor. It can only be funded with after-cash tax; no stocks or other certificates can go into your Roth, though once you buy your investment choices, you can certainly move them around.
If you make too much money, you can’t use a Roth IRA directly. As of 2021, your modified adjusted gross income needs to be under $139,000 for a single, $206,000 for married filing jointly. The money you put in the account can’t be used to reduce your taxable income; you need a Traditional IRA or a 401k for that.
A Roth IRA is an ideal retirement vehicle for someone who doesn’t expect an income drop in retirement. If you expect to receive income from a business or an inheritance, the post-tax money you put into a Roth will result in a non-taxed payout after you turn 59 and 1/2.
If you really want a Roth but your income is too high, you can set up a Traditional IRA and convert it. As of 2021, there are no income limits for a Traditional IRA. Be aware that there will be taxes to pay on the converted Traditional plan, but you’ll get the same tax-free growth of your investments as if you bought a Roth outright.
While it’s not a workaround, both Roth and Traditional IRA’s can be set up for a non-earning spouse. If you and your partner are raising a family and one of you has stayed home to care for children, starting either retirement account for their benefit is a great idea. Consider starting with a Traditional for the tax break, then add a Roth if your taxable income after retirement will be high.
Finally, if you’re a business owner who has children that work for you, be aware that you can create a Roth IRA. for your children. You can’t put more money in there than your child actually takes home, but over time you can get them off to a good start and allow them to learn the ropes of investing with a brokerage account.
Where Do I Start?
The fear of running out of money in retirement is downright terrifying and the availability of Social Security funds is questionable. If you’re getting a little nervous about your retirement dollars, it’s important to rank how you’re going to fund these accounts so you can quit worrying and let your money make money.
If you have access to a 401k, max it. This is a tax-deferred contribution; most of us will have less money after retirement, so the tax burden will be less. Plus, most employer plans offer a match, so if you prefer not to max it, make sure you at least put enough into your 401k to get the full match from your employer.
Depending on your income, consider a Roth IRA next. If your income isn’t high enough to block you from getting a Roth, building up post tax dollars for tax-free withdrawals after retirement will add a boost to your post-work finances.
If you need more of a tax break or your income is too high for a straightforward Roth, start a Traditional IRA. The tax break now can be helpful, and you can convert the Traditional to a Roth later if you will need tax-free dollars after retirement. You can also make non-deductible contributions to a Traditional IRA.
Why? Because, even though you’re not getting a break on your taxable income at this time, all your earnings on these dollars are tax-deferred. Trade and earn to your heart’s content. When you’re ready to retire and are facing an income drop, the tax burden will be lower on these funds.
A Word About RMD’s
RMD’s, or required minimum distributions, need to be monitored as soon as you turn 65. These are dollars that you have to take out of tax-deferred accounts so the government gets their money. While penalty for not taking your RMD won’t hit until 70, 70 and 1/2, or 72, the penalty can be severe.
If you have $100,000 in a Traditional IRA and the minimum required distribution is $4,000, you will have to pay tax on the RMD unless you donate it to a charity. If you don’t take the money, you will have to pay a $2,000 penalty. It’s a good idea to get in front of RMDs early to avoid the penalty, so don’t wait until you’re 70 to make these decisions.
There are no RMDs from a Roth IRA. If you have money in a Traditional IRA and are considering a conversion, carefully review the taxes required. They will likely be less than the penalty, leaving you with a Roth IRA that you can access if you need it or leave to your family.
A Roth IRA is a lucrative investment if you don’t need the tax break. Even if you exceed the income limits, you can still start a Roth. You can also start one for a non-earning spouse or for your children