A Roth IRA is a distinctive investment product that has been approved by the government and offers tax-free withdrawals because your contributions have already been taxed.
This investment has proven to be a legitimate long-term savings solution, particularly for young adults who are generally in a lower tax bracket now but will be in a higher bracket when they enter retirement. In fact, seniors and retirement-aged people who want to leave assets for their heirs will also benefit if they use proceeds from a Roth IRA because the proceeds are tax-free.
The Roth IRA has become very popular with working Americans who are concerned about planning for retirement. So much so, there are over 25 million households in the U.S. taking advantage of the Roth IRA because of the tax savings in the long run.
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How does a Roth IRA differ from a Traditional IRA?
There are distinct differences and similarities when compare a Roth IRA with a traditional one and it is the differences that make the Roth IRA so attractive to workers who are serious about retirement planning.How They are Similar:
- Contribution limits are the same. The 2019 contribution limits for both investment products are $6,000 if you are age 49 and under but go up to $7,000 once you reach age 50.
- Annual Deadline for Contributions. Contributions can be made each year up until “tax day” which is typically on or around April the 15th.
- The minimum investment requirement. Just like a traditional IRA, there is no minimum investment amount to open a Roth IRA.
- Management Fees. The management fees charged for a Roth IRA are typically the same amount charged for a traditional IRA.
How a Roth IRA and Traditional IRA Differ:
- Contributions: Your contributions to a Roth IRA are never tax deductible but qualified withdrawals are not taxable. With a traditional IRA, your contributions are deductible and qualified withdrawals are taxable.
- Distribution Requirements: Contrary to a traditional IRA, the internal revenue service does not require that you take distributions from your Roth IRA when you reach 70 ½.
- Income Limits: Whereas a traditional IRA has no limit on your income with when making contributions, your income can impact the amount of contributions made to a Roth IRA.
What are the Benefits of Contributing to a Roth IRA?
Along with the benefit of tax-free distributions when you enter retirement, a Roth IRA offers a variety of other benefits that include:
- Flexibility: When you own a Roth IRA, you can take the assets from your account without the stress of tax liability or penalties. In fact, you can use your Roth IRA to pay for college costs for you or a member of your family. You can even use the funds in your account to make a down payment on a home and not have to worry about any IRS penalties, although you will have to pay taxes on the withdrawal.
- Diversification of Taxes: Most retirees have several sources of income when they enter retirement. This income typically includes Social Security, other investment income, and distribution from retirement plans. Having multiple sources of income can move a retiree into a higher tax bracket which reduces their annual income. When you withdraw cash from your Roth IRA, you can take out income and reduce your overall tax liability.
- Distributions: There is no specific age when you must begin taking distributions from your Roth IRA like there is with a traditional IRA or 401K.
- Continue Saving while Retired: Unlike a traditional IRA where you must stop making tax-deductible contributions after you retire, you can continue making contributions to your Roth IRA even after you’ve retired.
How do I start Investing in a Roth IRA?
If you decide to open a Roth IRA, we typically recommend that you seek the advice of an experienced and reputable financial advisor but you can also do it yourself by using the following 3-step method:
- Determine You Contribution Amount – As we discussed earlier, your limit for contributing to your Roth IRA is $6000 unless you’re over 50 when you can contribute up to $7000. And remember, your deadline for contributions is “tax day” of the following year.
- Select your Investments – Next, you’ll need to select your investment accounts using your appetite for risk combined with your long-term goals for guidance. There are many types of investments you can select and this is when you’ll benefit from the advice of an investment professional.
- Select your Roth IRA Investment Manager – Here is when you can shop investment firms and discuss management fees that can impact your long-term saving goals. If you elected to get advice from an investment professional, he or she will likely recommend an investment firm to oversee your Roth IRA account.
What are the Income Rules for Investing in a Roth IRA?
Investors will be pleased to learn that the IRS has finally dramatically changed the income and contribution rules for a Roth IRA for 2019:
|CONTRIBUTION LIMITS||ROTH IRA|
|$7,000 if age 50 or More|
|Single Filers||Phase out starts at $122,000; ineligible at $137,000|
|Married filing jointly and qualifying widow(er)||Phase out starts at $173,000; ineligible at $203,000|
If your income exceeds the limit for a Roth IRA there is an alternative approach you can take called the “back door”.
To take advantage of the back door strategy, you would begin by putting non-deductible contributions in a traditional IRA since there is no income limit to deal with. Then, you would move the money into a Roth IRA by using a Roth Conversion.
Before deploying the back door alternative, it’s important that you understand your tax consequences because once you go through a Roth conversion, it is permanent and there is no method for moving the funds back to a traditional IRA.
Another Roth conversion drawback is if you are under 59 ½. Your funds that end up in going through the back door of a Roth IRA are considered converted funds by the IRS, not IRA contributions. Because the funds are converted, you will have a 5-year waiting period before you could access those funds without being subject to a penalty.
Is a Roth IRA a Better Choice for Me?
A Roth IRA can be an ideal investment solution if your earnings are within the income limits. Your Roth IRA provides more flexibility and you can withdraw your contributions (not your earnings) without worrying about penalties which makes access to funds much easier. And don’t forget, you can continue contributing to your Roth IRA even after retirement.
Just remember that if your income is too high you may want to consider using a LIRP to help fund your retirement.