Happy Birthday Roth IRAs

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2018 marks the 21st birthday for the Roth IRA retirement account – officially marking it a young adult, ready to go out and conquer the world!  The Roth IRA was originally passed in the Taxpayer Relief Act of 1997 and named after then Senator William Roth of Delaware[i].  Today, Roth IRA investments account for approximately $660 billion, or just 8.4% of the total IRA investments on record[ii].  Many wonder why the Roth IRA, with all its tax benefits, has not been more popular among investors.

What is a Roth IRA?

A Roth IRA is a type of retirement account for individuals.  Most are familiar with the traditional IRA in which the original contributions are generally tax deductible and the account benefits from tax-deferred growth until withdrawals are taken.  A Roth IRA operates opposite, but with the same end-goal of saving for retirement.  Roth IRA contributions are not tax deductible in the year made.  However, the after-tax dollars contributed to the Roth IRA benefit from tax-free growth, meaning both the original proceeds contributed plus all the accumulated growth during the years of investment can be withdrawn tax-free in retirement.  Depending on the life and gain on the investment, this tax-free benefit could be huge.

Who should open a Roth IRA?

Although each scenario should be independently analyzed, typically Roth IRAs are beneficial investments for:

1.      Young Investors – Youth is an advantage in this scenario because a 40-year-old investor could have 25+ working years and annual contribution opportunities during which their investment may grow.  Approximately 31% of current Roth IRA owners are under age 40[iii].

2.      Households Subject to a High-Income in Retirement – Although the future tax code is undeterminable, if a household expects a combination of retirement income (i.e.: pension income, social security income, dividends and interest, Required Minimum Distribution proceeds) that is equivalent to or greater than their working income, utilization of a Roth IRA may be a desirable strategy to control taxable income in retirement.  That is because Roth IRA withdrawals are generally tax-free, meaning you can take as much as you need, whenever you need, without worrying about taxation.  Unbeknownst to many, high income in retirement can result in a great deal of complexities such as increased taxes on Social Security benefits, higher Medicare premiums, a higher overall tax bracket and IRS required quarterly estimated tax payments. 

3.      Estate Planning – Roth IRAs are excellent estate planning tools.  Roth IRAs are not subject to Required Minimum Distributions, and therefore, can be left alone to grow tax-free.  Then, they can be passed tax-free to children or grandchildren through an Inherited Roth IRA account, extending the tax-free growth for another generation.

Additional Roth IRA Benefits[iv]

  • No Age Limit – After age 70½, the IRS does not allow individuals to contribute to their IRAs.  However, Roth IRAs are not subject to the age rule and contributions can continue as long as the person has eligible working income
  • Roth’s Utilized Alongside Work Sponsored Plans – An investor can participate in their company’s work sponsored plan, such as a 401K, and still contribute to a Roth IRA concurrently.
  • Easy Withdrawals – Generally speaking, as long as the Roth contribution has been invested for 5 years+, the account holder can withdraw gains from the account tax-free and penalty free. The basis, or original investment amount, is not subject to the 5-year rule, and may be withdrawn at any time.  

Roth IRA Contributions and Conversions

Annually, an investor can contribute a maximum of $5,500 per year to a Roth IRA, plus another $1,000 per year catch-up contribution after turning age 50.  Between January 1, 2018 and April 15, 2018, you may be able to make Roth IRA contributions for both 2017 and 2018. If you are getting your taxes prepared, ask your CPA.  

Keep in mind that Roth IRA contributions and conversions are different animals.  A Roth IRA conversion is the transfer of money from a pre-tax IRA account, to an after-tax Roth IRA account.  As the titles might suggest, the conversion is a taxable event and the transfer amount is considered earned income by the IRS.  Therefore, before making the conversion, check with your CPA how much a conversion of say $5,000, $10,000 or $15,000 might create in tax liability and only transfer what you are comfortable with.  Unlike Roth IRA contributions, conversions need to be completed before December 31st to count for that taxable year.

Due to the low Roth IRA annual contribution limits and phase out limits (if your Adjusted Gross Income is too high), many people are not able to make substantial investments directly into the Roth IRA.  Therefore, to take advantage of the Roth IRA tax benefits, investors may want to consider a Roth IRA conversion.  Consult with your CPA, attorney or Financial Advisor to ensure you are taking full advantage of opportunities.  

[i] https://en.wikipedia.org/wiki/Roth_IRA

[ii] https://www.ici.org/pdf/ten_facts_roth_iras.pdf

[iii] https://www.ici.org/pdf/ten_facts_roth_iras.pdf

[iv] Financial Planning: Why aren’t more clients using Roth IRAs?

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