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If you have any earned income and have the discipline to save even a little bit of your take home pay, a Roth IRA can be an ideal investment vehicle for you. Lets go over the 5 advantages of a Roth IRA.
1. Roth IRAs have fantastic tax benefits, for now…
Roth IRAs are retirement savings vehicles that if used properly can provide you with tax-free investment earnings after age 59 ½.1 When money is taken out of a Roth IRA in retirement, it all comes out tax-free as long as you have met a few simple requirements. The money you put in them (contributions) is not taxed again when taken out.
This tax advantage of Roth IRAs is their primary benefit over other “pre-tax” retirement savings vehicles such as Traditional IRAs, 401(k)s, 403(b)s, etc. which are also tax-deferred, but not tax free. The money in these types of pre-tax retirement are fully subject to taxation when withdrawn, which is the key distinction vs. a Roth IRA.
Another major reason you may choose a Roth IRA as opposed to pre-tax investment vehicles is that they think they will be in the same or a higher tax bracket in retirement. This may be because you don’t actually “retire” (some of us actually love what we do), have someone else operate your business for you, or continue to own other income producing assets like rental properties.
While no one knows what their tax rates will look like when they reach their respective retirement age, when you take funds from your Roth IRA in retirement you will not have to worry about tax implications when doing so. This allows for much more planning freedom and simplicity!
This leaves us with one simple question: Will Roth IRAs always be available?
Who knows. Hopefully they are here to stay but laws can and do change. Start one while you can.
2. You can take back out what you put in whenever you want
The dollars you contribute to your Roth IRA have already been taxed. There is no penalty or taxes due if you take that money back out. The investment earnings are the only component potentially subject to taxes and/or a 10% penalty – see 5-Year Rules for Roth.
Roth IRAs can provide you an extra layer of liquidity. If you already have earnings in your Roth, you can still make a withdrawal of only your contributions, and leave the earnings to continue growing and avoid taxes and penalty.
The option to access your money for any reason such as emergencies (although you should have a cash emergency fund already) is one of the major advantages of a Roth IRA.
3. Grandma and Grandpa can set your kids up with a Roth IRA
You can take advantage of having a Roth IRA at any age if you:
- Have earned income (w-2 or self-employment income)
- Aren’t ineligible to make a contribution to open a Roth IRA due to the income limitations set forth by the IRS.
- Currently $140,000 modified adjusted gross income for single filers, and $208,000 for Married Filing Joint (MFJ) filers.
Be careful not to contribute over the annual contribution limits for Roth IRAs which are $6,000 if under age 50, and $7,000 if over age 50 for 2021. These amounts typically adjust with inflation.
The IRS does not care where the actual money comes from to fund the Roth account. They just want to know if the account owner had adequate “earned income” for the year, and are under the Roth contribution income limits.
This means grandma, grandpa, or anyone else can gift you or your child money to contribute to a Roth IRA!
One strategy that can be used by families is that if a child has enough earned income from employment, other family members can gift them money to contribute to their Roth IRA.
It is important to remember that the amount contributed is not greater than the Roth IRA owner’s earned income or the maximum limits discussed.
Consider this for Birthdays or Holidays.
Let’s say you have a 15 year-old child that you employ in your business. Grandma can send your child $200 for their birthday every year for the next 10 years and your child agrees that it would be a smart idea to put the money away in their Roth each year…
If your child invested each annual gift of $200 for a 10 year period, then stopped contributing, and averaged an 8% return over a total 50 year time period, that account would be worth roughly $63,000 when they are age 65! TAX FREE!2
If the process is repeated with other potential gifts, or combined with the child’s own savings, you can see how the effects can be substantial!
4. I make too much money so I can’t have a Roth IRA. WRONG!
We will occasionally hear: “I make too much money”, or “my spouse and I make too much money”, “I can’t have a Roth IRA.”
Roth IRAs should not be thought of in a silo. There are multiple ways to get money into a Roth IRA.
So how can you still reap the advantages of a Roth IRA if you are above the income limitations?
Door Number 1: The Back-Door Roth IRA Strategy
This is a common strategy that requires only a small amount of extra work. It may not be around much longer as Congress has recently given the strategy extra attention.
Here’s how it works in a nutshell: You make a non-deductible IRA contribution up to the annual max to a traditional IRA, and then convert it to a Roth IRA.
This can be done no matter what income level you are at, and can even be done the very next day! The net tax result from this can be $0 – if you don’t have any other funded pre-tax IRAs – and you now have a funded Roth IRA!
It is important to note that this strategy may have tax implications due to the “pro-rata rule” which applies if you have any pre-tax money in an IRA before doing the conversion. There may be additional strategies available to you to avoid running into this issue.
Please contact your professional advisor or a firm like ours before considering this strategy.
Door Number 2: Contribute to a Roth 401(k) or make non-deductible 401(k) contributions
If your employer offers a 401(k) you likely have the ability to make Roth 401(k) contributions. Most 401(k) plans nowadays have Roth contribution options! The maximum amount you can contribute for 2021 is $19,500 if under age 50, and $26,000 if over age 50 (there is a $6,500 “catch-up contribution” available starting the year you turn 50).
If your plan allows for it, you actually may be able to contribute more by making non-deductible 401(k) contributions. Note that there is a limit of how much can be put into your employer plan in a given year. The 2021 limit of $58,000, or $64,500 if 50 or older. This includes your contributions and any employer matching contributions if applicable.
If your employer’s plan allows for it, you may take those non-deductible contributions, and subsequently roll or convert them into the Roth 401(k) account.
If your employer’s plan does not allow this feature, you can also wait and roll the non-deductible contributions to your own Roth IRA later if you separate from service, or if your plan allows for “in-service distributions”. Yet another advantage of a Roth IRA!
In this case, any potential earnings on those non-deductible contributions would remain pre-tax and should be rolled into a traditional IRA.
Note that if you receive an employer match or profit sharing, those employer contributions will never be Roth (after-tax) contributions, they will always be pre-tax.
Do you own a business with just you, or you and your spouse?
You can go open what is commonly referred to as a Solo(k)!
This is a 401(k) for businesses with one owner/employee, although a spouse can be added. These Solo(k)s also give you the ability to have Roth contributions and non-deductible contributions up to the previously stated limits.
Another advantage with these plans is that often times you can help in the creation of the plan documents and allow for some of the features previously mentioned!
Door Number 3: Roth Conversions
Do you have a traditional IRA or balance in your pre-tax 401(k) account?
You can convert a traditional IRA to a Roth IRA no matter what your income level is! This means you pay the taxes owed on the entire amount converted in the year you convert it.
Your employer’s plan may also allow conversions of pre-tax 401(k) funds to the Roth 401(k) account. This is a taxable event. Please consult with your current advisors, or a firm like ours before considering this strategy.
Why would I intentionally pay taxes now? Maybe you are in a lower tax bracket and have more room to recognize income in that low tax bracket.
You can take advantage of that while you have a chance and essentially lock in paying a low tax rate vs potentially paying much higher rates later. This is currently the case for most people since the lower tax rates from the Tax Cuts and Jobs Act sunset after 2025.
5. Roth IRAs do not have required minimum distributions (RMD)
“Required minimum distributions” or “RMDs” are applicable to most pre-tax retirement accounts – and Roth 401(k)s – which says that upon obtaining age 72 you must start taking a minimum amount out of your retirement accounts.
That minimum withdrawal amount is based on your account value as of 12/31 of the prior year and a life-expectancy factor provided by the IRS.
This is because in pre-tax accounts like IRAs or 401(k)s, you have essentially been “sheltering” that money from taxation for so many years, and now aunt Iris (IRS) wants those tax-dollars!
For 401(k)s the rules for RMDs are slightly different than IRAs:
- If you are not an owner of more than 5%, over age 72 and still working, you can delay RMDs until April 1st of the year following the year you separate from service. Whew, that was a mouth full.
- If you are a 5% or more owner of the company with the plan, you are subject to this RMD rule starting at age 72, even if you are still working!
- Some organizations that offer a retirement plan can require distributions from the plan at an even younger age!
- Roth 401(k) accounts do have RMDs! However you can avoid them by eventually rolling your Roth 401(k) money into to a Roth IRA!
You guessed it, Roth IRAs do not have required minimum distributions! You can keep that money in there for as long as you’d like (unless you have inherited a Roth account).
This may be the single greatest advantage of a Roth IRA because those pesky RMDs from pre-tax accounts can cause a myriad of planning issues later in life and wreak havoc on your tax situation.
The Bottom Line
A Roth IRA can have numerous advantages vs. other investment vehicles for most people, you just have to understand the strategies involved.
- There are a ton of unique planning techniques that can be used, not all of which were mentioned here.
- There are also other rules to watch out for that may apply to some of these strategies. One example is the 5-Year rule that applies to Roth IRA and 401(k) contributions and conversions.
- Consult with a professional when creating your Roth IRA strategies to see how they can fit into your overall financial plan.
Bonus Planning Tip:
You should open a Roth IRA as soon as you can using any of the previously discussed methods, or by simply making a contribution. This will open you up to more opportunities down the road. See our blog here for more ideas to build wealth using Roth IRAs.
Cameron Valadez is a CERTIFIED FINANCIAL PLANNER™ located in Riverside and Orange County, CA.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
1 Roth distributions from earnings are tax-free if your initial contribution to the account was made at least five years ago and you meet one of the following conditions:
– you’re age 59½
– you’re disabled
-you’re purchasing a first home (up to $10,000 lifetime maximum)
Distributions from earnings are not subject to the 10% penalty if you qualify for an IRS exception — please consult with your tax advisor for details. Distributions from a conversion amount must satisfy a five-year investment period to avoid the 10% penalty. This pertains only to the conversion amount that was treated as income for tax purposes.
2 The hypothetical examples are for illustration purposes only and are not intended to be representative of actual results or any specific investment, which will fluctuate in value. The determinations made by these examples are and not intended to be reflective of results you can expect to achieve, and no taxes or fees/expenses are included in the calculations, which would reduce the figures shown. Please keep in mind that it is possible to lose money by investing and actual results will vary.
The information provided is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The strategies mentioned here may not be suitable for everyone. Each investor needs to review strategies for his or her own particular situation before making any financial or investment decisions.
Cameron Valadez does not provide legal or tax advice. Please consult a professional prior to making financial decisions.
Information is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.