Dating back to 1998, Roth IRAs have been around for over 25 years. Although this type of retirement account has been around for a while, it is still as beneficial as it was when it was first introduced. Throughout this article, we’ll take a deep dive into the different types of Roth accounts, the pros and cons of them, and how you can utilize them for your own retirement planning.
The Roth IRA is a tax-advantaged individual retirement savings account. The money you contribute to the account is after-tax money, meaning you have already paid taxes on it. Once you’ve contributed money to the account, the funds can then be invested in a variety of investments of your choosing. This can vary from stocks, bonds, mutual funds, ETFs, and cash equivalents. The investment you choose should align with the purpose of your money. As capital gains, dividends, and interest are earned on your investment, you will not have taxes on the investment earnings, allowing more money to stay in your account and compound for you over time.
Once you are ready to take money out of your account you can potentially pull out all your money tax-free. There are two conditions you must satisfy to take tax-free withdrawals from the account. The first condition is you must be over 59-1/2 years old and the second is that it has been at least five years since you made your first contribution.
The downside to a Roth account is it is less flexible than other account options. If you decide to take any earnings from your Roth account before you’re over the age of 59-1/2 you will have to pay taxes and a 10% early withdrawal penalty. This makes it crucial for you to only be contributing long-term money to this type of account.
There are a few provisions that allow you to take early withdrawals penalty- and tax-free. The first is withdrawing your contributions. Since the money you contribute to the account is after-tax money, you can withdraw your contributions at any age without penalty or tax. Just be careful you do not withdraw more than you contributed because the earnings will be subject to penalty and tax. The second is for a first-time home purchase. The rules allow for you to take up to $10,000 out of your Roth IRA penalty- and tax-free if it is used for a first-time home purchase. The third option for penalty- and tax-free early withdrawals is if you become disabled. If you do not satisfy any of the above conditions, then the earnings you take from your Roth IRA will have taxes at your ordinary income rate and will also have a 10% early withdrawal penalty due.
Another type of Roth account that is available is called a Roth 401(k). This is an employer-sponsored retirement account that allows after-tax contributions made automatically from your paycheck. This account works similarly to a Roth IRA in the way after-tax money is contributed, invested, and potentially withdrawn tax-free. The same rule applies that you must be over 59-1/2 to take money tax-free from the account. The Roth 401(k) differs from the Roth IRA in the investments you can make. With the Roth 401(k) you are limited to a selection of investment options chosen by the employer but with the Roth IRA, you have a much broader choice of investments. One benefit of the Roth 401(k) over the Roth IRA is the contribution and income limit. The Roth 401(k) has a higher contribution limit and does not have an income limitation, whereas the Roth IRA does not allow individuals with high income to make contributions to the account.
The good news is if you are a high earner and want to make contributions to your Roth IRA there is a strategy that will still allow you to. It is known as a backdoor Roth IRA contribution. To use this strategy, you contribute to a traditional IRA (without a balance) and then immediately convert these funds to a Roth IRA. You will not be able to take a tax deduction for the contribution to your traditional IRA but by converting them to a Roth IRA you will reap the benefits of this account. It’s crucial you work with the appropriate professional to complete this strategy.
Having Roth accounts in retirement allows for increased flexibility in your overall retirement plan. One of the biggest benefits is the ability to make tax-free withdrawals – this allows you to manage your tax liability throughout your retirement years. Another benefit is Roth IRAs do not have required minimum distributions (RMDs) during your lifetime. Since you are not forced to take out a certain amount each year, you can have more flexibility in managing withdrawals based on your own income and tax situation. Lastly, it can add flexibility to your estate plans. Roth accounts can be passed to heirs tax-free. By spending down on taxable assets and deferring withdrawals from your Roth accounts, you can leave a tax-free asset to your beneficiaries.
A Roth account can be a powerful tool in planning for retirement. However, it’s just one piece of the puzzle. By planning ahead you can take advantage of other pieces of the puzzle that lead you to a life well-lived.
-by Jacob Young, AAMS®
Financial Advisor, RJFS
313 East 10th Ave.
Bowling Green, KY 42101
Phone: 270-846-2656
The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of the author, and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
Ben Smith Life Compass Financial is not a registered broker/dealer and is independent of Raymond James Financial Services, Inc. Securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc.
Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
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