What’s the Deal with Roth IRAs?

  • Roth IRA

I’m sure that you’ve heard of the Roth IRA. After all, they have been around since 1997 but they have not been available to many higher-income earners due to restrictions imposed by Congress.

The good news is that starting in 2010 Roth IRA conversions became allowable for everyone regardless of their income level. And, depending on your Adjusted Gross Income, it also may be possible to make annual contributions to a Roth IRA.

Roth IRA Basics

There are two main ways to participate in Roth IRAs; either through annual contributions or conversions.

Annual Contributions to Roth IRAs

If your Adjusted Gross Income (AGI) does not exceed certain limits (In 2014: $114,000 if your taxes are filed as Single and $181,000 if your taxes are filed Jointly) you may make an annual contribution to a Roth IRA.

Your contributions are made with after-tax dollars and earnings compound tax-deferred. The great news is that with a Roth IRA you can take your contributions out tax-free at any time.

Withdrawals of earnings are tax-free, as long as the Roth has been in existence at least five years and withdrawals are taken after age 59 ½.

*Careful! Tax penalties apply on withdrawals of earnings prior to age 59 ½ unless an exception applies such as death, disability, medical expenses, first-time home purchase, or higher education expenses.

Because Roth IRAs offer such great tax benefits, you’re only able to contribute a certain amount to your plan.

In 2014, you are able to contribute up to $5,500 to a Roth IRA (you and your spouse can each contribute that amount). If you’re over the age of 50, you can contribute an extra $1,000 per year.

Conversions to a Roth IRA

In 2010, the income limit for conversions was lifted. This means that, regardless of your income, you have the ability to convert Traditional IRAs to Roth IRAs without paying a tax penalty.

Advantages of Roth IRA Conversions

  • A Roth IRA conversion can help you accumulate tax-free assets during retirement.
  • A Roth IRA owner may continue to make after-tax contributions at any age. This is unlike a Traditional IRA where no contributions are allowed after 70 ½.
  • There are no required minimum distributions (RMDs) from Roth IRAs during your lifetime.
  • Since no income tax is due on qualifying distributions from a Roth IRA, a Roth can make life easier for your heirs by leaving them tax-free assets.

Tax Rates Can Make a Difference

With all the benefits, it is important to take into consideration if a Roth IRA conversion is right for you. One way to determine that is by answering these two questions:

  • Do you think that, generally, tax rates will increase or decrease during your retirement?
  • Do you think that you’ll be in a lower or higher tax bracket when you retire than you are now?

When you make Roth IRA contributions or make a Roth IRA conversion you are essentially pre-paying income taxes. Therefore it would make sense for you to have a Roth IRA if you believe tax rates will increase during your retirement.

Some people believe that it’s a mistake to pre-pay taxes because you will lose the “time value of money” on the taxes paid. However, this is not the case, due to the following rule:

A pre-tax dollar in a tax-deferred investment will have exactly the same after-tax future value as a post-tax dollar in a tax-free investment, if you assume that tax rates stay constant.

In other words, if taxes stay the exact same as they are today, you will be no further ahead orbehind by contributing to a Roth IRA or Traditional IRA.

Let me give you an example.

Scenario A: Suppose you put $1 of pre-tax money into a Traditional IRA and over 10 years it compounds (@ 8% annual return) into $2.16. You then pay federal/state income tax at a hypothetical 30% rate, leaving $1.51 after taking a taxable withdrawal.

Scenario B: Suppose that you put 70 cents of post-tax money ($1 less 30 cents tax) into a Roth and it compounds over ten years at the same 8% to produce $1.51. Since the full amount can be withdrawn tax-free, the amount available for retirement security is exactly the same as in the Traditional IRA.

The result? The same in either scenario.

Of course, it’s impossible to know whether federal, state and local income tax rates will go up or down in the future. Due to this uncertainty, one strategy is to hedge against tax rate changes by dividing retirement money between Traditional and Roth IRAs.

Even if you aren’t sure about the wisdom of Roth conversions, it can be useful to contribute or convert a small amount to a Roth now. Anyone over age 59 ½ is allowed to take tax-free withdrawals from Roth IRAs starting five years after the account was opened. Even a small amount put into a Roth now starts the “five-year clock” ticking.

Roth IRAs have become a viable planning tool that can help to increase tax-free asset accumulation and increase simplicity during retirement.

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2 Comments

  1. Janine

    I have a traditional IRA. I will be taxed when I take it out. Would it be to my advantage to switch to a Roth IRA. Do I understand right that it is taxed each year?

    • It would be advantageous to convert to a Roth IRA now if you believe that you will be in a higher tax bracket when you retire. If you’ll be in a lower tax bracket when you retire, it is better to keep your money in a traditional IRA. With a Roth IRA, it is tax-deferred (you are not required to pay taxes each year) and when you pull out those funds, qualified distributions will be tax-free.

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