We talked about what an IRA is in a previous post, and more specifically went over the Traditional IRA so you can review that post if you need a refresher! Today, we’re going to talk about the Roth IRA, the “taxed up front so you don’t get taxed later” counterpart to the Traditional IRA.
So we’ve got our apple carts all lined up, and now we’re looking at the Roth IRA apple cart. This cart is special, because it has tax benefits that you don’t get with the other carts (Traditional IRA, regular Brokerage account, even a Money Market account). You have to pay taxes before contributing to the Roth IRA, but when you follow the distribution rules laid out by the IRS the withdrawals are completely tax free later on! There are a lot of rules that go along with the Roth IRA (because it’s a pretty good deal so it can’t be completely easy, right?), so let’s break those down next.
The Technical Stuff…
As I mentioned above, the money you contribute to your Roth IRA is already taxed (you might hear the term after-tax thrown around, same thing). Once your money is in the Roth IRA, and invested, the growth on that money is tax-deferred.
What does tax-deferred growth mean? Tax-deferred growth is a really important part of an investing strategy, especially if you’re in a high tax bracket (we’ll assume that includes the 22% tax bracket and above). With a regular investment account, you have to pay taxes each year on some of the earnings (usually called interest and dividends, or capital gain distributions…we’ll talk about that another time), so that’s literally money that is going to the IRS rather than remaining in your account. When you have an account that has tax-deferred growth (like an IRA), you don’t pay taxes each year on the interest, dividends, or capital gains. When you look at that benefit over the course of years and decades, those tax savings can make a huge difference.
Back to the Technical Stuff!
So your Roth IRA is funded with after-tax money and it grows tax-deferred. The BIGGEST benefit comes at the withdrawal phase, because when you follow the IRS guidelines for distributions, the money you take out is completely tax-free. No taxes are paid on any withdrawal from a Roth IRA when both of the following criteria are met:
- You are age 59 ½ or older (to the day, and not even a day before your half-birthday!)
- You have had the Roth IRA for 5 years or longer
Additionally, since you’ve already paid taxes on the money you put in, those dollars are always available to be taken back out without any penalties at any time.
How much can I contribute?
Like the Traditional IRA, there are limits to how much you can put into your Roth IRA each year. Also like the Traditional IRA, the amount you are allowed to contribute is based on how much income you earn, and the limits are different for single tax filers, couples who are married filing jointly, and couples who are married filing separately.
Here’s the handy-dandy chart that explains exactly what the limits are for different income and tax filing scenarios for Roth IRAs:
Also like the Traditional IRA, the maximum you are allowed to contribute in 2020 and 2021 is $6,000 for people age 49 and under, and $7,000 for people age 50 and over. Another similarity: if you make less than $6,000 (or $7,000 if you’re over age 50), you can only contribute as much as you earned. For our button store employee who earned $5,000, they can only contribute up to $5,000 to an IRA. If they made $10,000 and they’re married, they can contribute to their own IRA and their spouse’s IRA, up to the amount that they earned.
What if I need to use my money before retirement?
As with all IRAs, the money you save into your IRA is really, really supposed to be for retirement according to the IRS. There are some exceptions to the withdrawal penalties, but for the most part, you will pay income taxes plus a 10% penalty tax on the growth in the Roth IRA if you take money out before you reach age 59 ½.
Do Roth IRAs require RMDs?
NO! This is the other very special and beneficial part of the Roth IRA rules. With any other IRA type, you are required to take distributions once you reach age 72. So even if you don’t need extra income, you have to take it out and pay taxes on it because the IRS says so. With Roth IRAs, however, you can leave the money as long as you like and you never have to take a withdrawal if you don’t need it. For people with high incomes during retirement, the Roth IRA bucket can be a really helpful tool to keep taxes lower overall.
My employer offers a Roth 401(k), is that the same thing?
The concept and tax benefits are the same, but there are differences because of the fact that it’s a 401(k) rather than an IRA. Some 401(k) plans also allow “after-tax” contributions, which are eventually treated just like Roth contributions. We’ll talk about the benefits of using those strategies in a separate post, so stay tuned!
As always, there are other details and intricacies that you may need to know, so don’t treat this post as the only resource you need when opening a Roth IRA. Rules and regulations can change from year to year as well, so always be sure to check for updates or ask your financial advisor about any changes. And once again, here’s the IRA reading list:
- What is…a Traditional IRA?
- What is…a SIMPLE IRA?
- What is…a SEP IRA?
- What is…a Coverdell IRA?
- What is…an Inherited IRA?
- What is…a Rollover IRA?
Juncture Wealth Strategies cannot and does not provide tax or legal advice. For specific advice on these aspects of your overall financial plan, you should consult your tax advisor or attorney. This is provided as a summary only and does not guarantee accuracy.