You know how when you buy a new car, you suddenly see ‘your’ car everywhere, though you never really noticed it before? That’s what’s been happening with me and the Roth IRA lately.
They’ve been around for over 20 years but lately, it seems they’re popping up in articles, client meetings and planning cases left and right. They offer some opportunities that simply don’t exist with other retirement savings vehicles. When combined with your other assets, can provide a great balance of investment opportunities.
As they come up in conversations with my client families, I realize that several of the things that make Roth IRA’s unique are unknown to many. Today, I provide you with a rundown of the basic, and not so basic, opportunities that lie within the humble Roth IRA.
What makes a Roth IRA so great?
They provide tax diversification. Contributions to a Roth IRA are made with after tax dollars. (Unlike most of your other retirement accounts, in which contributions are made pretax.) When you’re ready for withdrawals at retirement, they are not taxable. (Unlike most of your other retirement accounts, which will be 100% taxable as ordinary income).
They provide a backup to your liquid emergency fund. A little known fact about Roth IRA’s: you can withdraw your contributions at any time, tax and penalty free. Just remember, this account will (in most cases) be invested and therefore exposed to market risk. (Earnings are subject to tax and penalty.)
They can provide an alternative to college savings plans. Withdrawals for education expenses for you, your spouse, child, grandchild or great grandchild are considered qualified distributions from an IRA.
They can provide help with a down payment on your first home. Another little-known fact about Roth IRA’s: you can withdraw up to $10,000 to use toward buying your first home.
They can provide a backup to pay for medical emergencies. You can use your Roth IRA to pay for unreimbursed medical expenses that are over 10% of your AGI. It can pay your insurance premiums should you become unemployed. It can pay out in the case of death or disability .
While this is true that some of the aforementioned benefits are true also of Traditional IRA’s, Roth IRA’s have the bonus of not being taxable when withdrawn for qualified expenses (Traditional IRA’s would be).
What are the drawbacks?
Contribution limits. Typically, you’re only able to contribute $5500/year to a Roth IRA. ($6500/year if you’re over 50.)
Income limits. If you make over $135k (single) or $199k (joint), you’re no longer eligible to contribute to a Roth IRA. This is a big reason that I encourage young folks to start and fund them while they can. Related, you must have earned income to contribute to a Roth IRA (e.g. you must be employed). However, conversions from Traditional IRA’s to Roth IRA’s can be done at any age.
Distribution limits. Generally speaking, the Roth IRA account must be at least 5 years old and you yourself must be over 59.5 years old to take a distribution from your Roth IRA without penalty. This is one reason I suggest people start a Roth IRA sooner than later, even if they can’t fully fund it right away. Get the clock ticking on the 5 year mark and you’re that much closer to being able to make qualified distributions.
How can I fund a Roth IRA?
Roth Conversion. If you currently have a Traditional IRA, you can convert assets to a Roth IRA. Taxes are usually a huge decision factor in making this move, as every dollar you choose to convert is taxable. We often work with clients and their tax processionals at yearend to decide how much they’re able to recognize in taxes without setting off the chain of unfortunate side-effects. Those can include bumping into a higher tax bracket, higher taxability of capital gain, increase in Medicare premiums and an increase in taxability of Social Security, to name a few.
Rollover of after-tax retirement dollars. Some clients have basis in their qualified retirement plans, which means that they made some contributions after tax and some pretax. In these cases, you can separate the after-tax dollars into a Roth IRA and the pretax dollars into a Traditional IRA. The catch is it has to still live within an employer plan and cannot already be comingled into a Traditional IRA. This is a unique circumstance, but a definite planning opportunity for those who fit the bill.
Contribute to a Roth 401k. This is an opportunity I often encourage my clients to pursue if available to them. The contribution / income limits I mentioned earlier don’t apply to Roth 401k plans. You can contribute up to $18,500 (or $24,500 if you’re over 50). This is especially easy to do if you’re a solo, self-employed individual and can afford to tuck most of your income away for retirement savings.
Backdoor Contributions. This is best for taxpayers who are under 70.5 years old and have phased out of the income limits described above. As long as you’re not covered by a qualified plan, you can make a contribution to a Traditional IRA. Immediately after, you convert that contribution to a Roth IRA.
In Summary
Roth IRA accounts are often a part of a powerful financial plan. They provide tax diversification, a back up to your emergency savings as well as some unique uses outside retirement.
This is one of the reasons I commonly recommend clients who are eligible to start a Roth IRA. It’s great for those of you who are wondering, “What if my (grand)child doesn’t want to go to college?” The Roth IRA provides alternative uses.
All this said, withdrawals from your Roth IRA that are outside obvious, qualified retirement use should be handled with care. As I mentioned, some of these loopholes are unknown to many, including advisors and administrative staff working on the backend of your investment accounts. If you have questions about whether or not a Roth IRA is right for your planning goals, give us a call. We’re here to help.
