Roth IRAs Explained

What is a Roth IRA?

A Roth IRA is a type of individual retirement account that allows you to contribute after-tax dollars; your contributions and earnings can grow tax-free, and there are no required minimum distributions¹. You can take distributions from your Roth IRA tax-free and penalty-free after age 59½ and once the account has been open and funded for five years. Combined, these benefits can be part of a successful retirement plan, allowing you to grow your wealth while still managing your income in a tax-efficient manner.

Like a traditional IRA, a Roth IRA can be funded through regular contributions, spousal IRA contributions, rollover contributions, transfers, and conversions (more on Roth conversions below). Contribution limits are the same for traditional and Roth IRAs and apply across all your IRAs.

A Type of Account, Not a Type of Investment

A Roth IRA is a type of account, not a type of investment. Once your account is funded, you may use various investment options within a Roth IRA, including mutual funds, stocks, bonds, exchange-traded funds (ETFs), and other securities.

A person must have earned income to contribute to a Roth IRA; a taxpayer whose income consisted solely of investment income would not be eligible to contribute to a Roth IRA. And, there are income limits to be eligible to contribute directly to these accounts. This is one of the reasons Roth IRAs are frequently viewed as an investment tool for younger investors. Young retirement savers will often meet the income eligibility requirements and still be in a low bracket. This means that the tax deduction associated with a Traditional IRA contribution may not have the same value as it does to a worker in a higher tax bracket. However, it can also be an effective tool for investors close to and in retirement if it’s accessed by converting other assets and care is taken in how the conversion is paid for.

Roth IRA for Retirement Planning

individual retirement accounts

If you think you’ll be in the same or a higher tax bracket in retirement than you are now, a Roth may be suitable for your retirement plan. When contemplating this question, don’t forget to consider the effect of your income level on other financial factors such as your Medicare premium (IRMAA), eligibility for tax credits, and whether your taxable income will subject you to other taxes such as the Net Investment Income Tax. Taxes often increase in retirement as deductions decrease, but income from pensions, stock and bond investments, real estate, and other income streams may increase. In addition, the required minimum distributions from other qualified accounts can push you into a higher tax bracket.

A Roth IRA allows you to structure your investments so that high-growth assets with potentially higher tax consequences can be held in a tax-advantageous account.

Traditional accounts require a minimum amount to be withdrawn every year, beginning at age 72. The minimum is a function of the account balance and the account holder’s age, so it usually increases over time. Because you’ve already paid the taxes, Roth accounts do not have RMDs. This allows you to control your income and taxable income in any given year.

Estate Planning Considerations

Since you’ve already paid the taxes on a Roth IRA, you are providing your heirs with tax-free funds that don’t count against the estate tax exemption.

You must designate a beneficiary; some non-spouse beneficiaries will have only ten years to withdraw all the assets.

What is a Roth Conversion?

Contributions into Roth accounts are made with post-tax funds. Because taxes are paid upfront, no taxes are due when the funds are withdrawn, and the account can grow tax-free.

Traditional accounts allow you to defer taxes on the funds by contributing with pre-tax dollars. This lowers your taxable income in the years in which you contribute. But, taxes will be due on your distributions when you withdraw funds from your Traditional IRA.

A Roth conversion is not the same as a Roth contribution

Roth contributions are limited to an annual maximum set by the IRS each year. In addition, an income limit affects the eligibility to contribute directly to a Roth IRA. However, the contribution limit and the income limit do not apply to conversions into a Roth IRA account.

When you convert funds to a Roth account, the taxes on those amounts will be incurred in the tax year you convert. Therefore, the tax due on a potential Roth conversion is often the determining factor as to whether to execute a conversion and the appropriate amount for a conversion in any given year.

If you believe that you will be subject to higher taxes in the future, a Roth conversion is a way to lock in today’s tax rates.

Once the conversion is complete, the retiree can enjoy tax-free growth of the account and tax-free qualified withdrawals.

Withdrawals of contributions and their growth will be tax-free if you are at least 59 1/2 years old and your Roth IRA has been funded for at least five years. Any Roth conversions and the associated growth can be withdrawn tax-free once five years have passed. Each conversion must be tracked on its timeline.

Roth Conversion for Retirement Planning

Roth conversions can work very well to create flexibility in retirement income streams and streamline estate planning. Careful deployment can minimize the tax hit during the conversion phase.

Consider the Timing

There is a sweet spot for a Roth conversion. After retirement, but before you begin to claim Social Security and before RMDs kick in, your income is likely to be lower, and you may be in a lower tax bracket. Spreading the Roth conversion out over several years in this time frame can lower your total tax liability.

Even more beneficial is to start saving and investing in a Roth account early in your career. In fact, it is one of the best ways to teach young adults about investing and the power of compounding dollars. The longer your account has to grow tax-free, the better the potential result will be when you are ultimately ready to withdraw those funds.

This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. We examine these factors and many others during our financial planning process to determine appropriate financial strategies for YOU.

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