When should you consider a Roth IRA?
I believe almost everyone who can have a Roth IRA should have a Roth IRA.
The biggest reason to open and contribute to (or convert an existing retirement account to) a Roth is if you expect an increase in your future tax rates. Tax rates change for many reasons, but can be affected by life changes, such as making more money, becoming a surviving spouse, or expecting current tax rates to expire as legislated.
A Roth may work for those who want to save for college and their own retirement at the same time. If you keep up with your tax basis via IRS Form 8606 – Nondeductible IRAs – you may be able to withdraw the basis any time, for any reason, tax free. This basis could be used for college expenses. If you need additional funds, earnings can be withdrawn before age 59 1/2 if used for qualified educational expenses. Withdrawn earnings would be subject to income tax (per IRS publication 590) but not the 10% early withdrawal penalty.
Contributions and conversions to a Roth IRA are taxed today – at your current rate – but later, when you withdraw money in retirement, you pay no federal or state taxes. This means every dollar grows tax-free and can be withdrawn tax-free (as long as you’ve owned the account for 5 years and are age 59 1/2 or older).
Many younger investors, such as those early in their careers, could benefit from a Roth. There are no age limits to opening a Roth, however you (or your spouse) must have taxable income to contribute. There are no income requirements for converting a Traditional IRA to a Roth IRA.
If you don’t already have a Roth, the case could be made to get an account started now because of “the 5-year rule.” Roth IRAs open more than 5 years receive favorable tax treatment in certain circumstances – even if the balance is $1. Having a Roth past its fifth birthday is helpful, even if you waited to contribute money or convert years from now.
When would a Roth IRA not make sense?
There are three instances where a Roth IRA would not make sense:
1) If you expect to be in a lower tax bracket in the future: Traditional IRAs are pre-taxed, meaning you get a tax break today and only pay taxes on withdrawals in retirement. In this scenario, every dollar put in – plus the growth – is taxed upon withdrawal. Therefore, a Traditional IRA can be more advantageous for those in high tax brackets who anticipate their income will decrease in retirement.
2) If having the account results in additional costs to you (beyond the tax liability from converting money from a Traditional IRA to a Roth IRA): Converting a Traditional IRA to a Roth may increase the amount of your Social Security subject to income tax. That’s because conversions are included in calculations that determine how much of your Social Security income is taxable, and possibly even how much you pay for Medicare premiums.
3) Your income exceeds the limits for a Roth IRA: Income limits apply to Roth contributions, but not conversions. Even if you meet the requirements to open an account, you may not qualify to take full advantage of its benefits. Your ability to contribute to a Roth depends on your modified adjusted gross income (MAGI) and income tax filing status.
What are some alternatives to a Roth IRA?
A Roth 401(k) is an employer-sponsored retirement savings vehicle. A Roth 403(b) would be offered by nonprofits and schools. These plans operate similarly to 401(k)s but may have additional considerations.
Is a Roth IRA worth it?
Retirement is the biggest financial goal for most people, but there are often multiple goals.
Roth IRAs let you access your contributions (basis) anytime, for any reason, without tax or penalty. This is one reason why a Roth IRA can be the first place for young people to start their emergency fund. (Keep track of your basis on IRS Form 8606 when you file your yearly return.)
Keep in mind, however, that any earnings withdrawn before age 59 1/2 may be subject to ordinary income tax plus a 10% federal penalty tax. (The penalty tax can be waived for earnings if the funds are used for first-time home purchases, qualified educational expenses, or for health insurance premiums while unemployed (per IRS Pub. 590).
A few other things you should know about Roth IRAs:
Traditional IRAs have required minimum distributions (RMDs) – a specified amount you must withdraw annually after a set age – regardless of how much money you actually need.
In comparison, Roth IRAs do not have RMDs. This provides you the flexibility in retirement to withdraw money based on your lifestyle and expense needs. This means your funds can remain invested longer, allowing the chance for additional growth through your retirement years.
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