Roth IRAs are a popular savings tool, but their full potential is still underappreciated by many investors. Given their flexibility and optionality, Roth IRAs can be an important investment vehicle for both those starting out in their career and those starting to think about retirement.
How Do Roth IRAs Work?
Unlike a traditional IRA where you save on taxes up front, a contribution to a Roth IRA is made with after-tax dollars. However, once the contribution is made, the growth of the investments inside the Roth IRA is tax free and withdrawals are tax-free if they meet certain qualifications.
What is the Tax Rationale for Investing in a Roth IRA?
Although choosing a Roth IRA over a traditional IRA will cost more in taxes upfront, it may result in less taxes over an investor’s lifetime. The key is that an investor’s tax rates may change over time. If they are able to invest in a Roth IRA when they are in a low tax rate and then withdraw the funds when they are in a higher tax rate, the Roth IRA will have been the better choice over a traditional IRA. This is demonstrated in the examples below.
In Scenario 1, the starting marginal tax rate is 12% and the ending marginal tax rate is 24%. Since the starting tax rate is lower, the Roth IRA is more attractive as taxes are paid upfront. In Scenario 2, the starting marginal tax rate is 24% and the ending marginal tax rate is 12%. Since the starting tax rate is higher, the traditional IRA is more attractive in this scenario as taxes are paid upon withdrawal from the account.
What are the Rules Around Taking Withdrawals from a Roth IRA?
An investor’s contributions to a Roth IRA may be withdrawn at any time without penalty or tax. This provision means you could take these funds to buy your first house, pay for college or even start a new business.
Beyond your contributions, the earnings in your Roth can be withdrawn tax-free and penalty-free when you reach age 59 ½ and it has been five years since you first contributed to a Roth IRA. If the earnings are withdrawn before meeting these two conditions, ordinary income taxes and a 10% penalty may need to be paid.
However, there are exceptions where taxes and the penalty may be avoided. If the account has been open for 5 years and you are under age 59 ½, your earnings will not be subject to taxes if you meet the following conditions:
- The withdrawal is used to pay for qualified education expenses.
- The withdrawal is used to pay for a first-time home purchase (up to lifetime maximum of $10,000).
- The withdrawal is used to pay for health insurance while you are unemployed.
- The withdrawal is used to pay for unreimbursed medical bills that are more than 7.5% of your adjusted gross income.
- You are permanently disabled.
Another important aspect of the Roth IRA is that there are no required minimum distributions (unlike traditional IRAs which have required minimum distributions after reaching age 72). This allows the Roth IRA to continue to grow tax free. The flexibility around distributions also allows savers more options regarding taxes. If a large cash need comes up, having funds in a Roth IRA can allow one to avoid the additional taxes that would come with taxable distribution from a traditional IRA.
Who Can Contribute to a Roth IRA?
For 2021, individuals can contribute $6,000 to a Roth IRA ($7,000 if above 50). For an individual to be able to contribute, they (or their spouse) must have enough earned income to cover the amount of the contribution. There is no age limit on who can contribute.
There are income limits. As shown in the table below, the eligibility for those filing taxes as single starts to phase out at a modified adjusted gross income of $125,000. For those filing taxes as married filing jointly, eligibility begins to phase out at $198,000.
Source: https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021
For some savers who are above the contribution limit, it may make sense for them to make a non-deductible contribution to a traditional IRA and then convert this to a Roth IRA. This is referred to as a “backdoor” Roth contribution and is a way for some high earners to contribute more funds to a tax-advantaged account.
Takeaways
The Roth IRA can be an important savings vehicle due to its flexibility and tax-advantaged status. The ability to withdraw contributions penalty-free gives investors the option to save for retirement, then use the funds for other purposes if needed. The Roth IRA can also save taxes for investors who expect to be in a higher tax bracket later in life.
Similar to our investing approach, we generally recommend investors to be diversified across types of retirement accounts, although each investor’s situation is unique. If you would like to talk to a financial planner about whether a Roth IRA makes sense for you, please schedule a call.