A Roth IRA is an individual retirement account funded with after-tax dollars. You can’t deduct contributions to a Roth IRA at tax time, but you can withdraw your money tax-free in retirement. A Roth IRA is a popular choice for young people just starting out in their careers. Many work with a financial advisor to optimize their retirement strategy. Let’s take a look at the Roth IRA and break down how it could fit into your retirement goals.
Understanding How a Roth IRA Works
Today you have many choices to save for retirement. One popular retirement investment vehicle is the Roth IRA. You fund a Roth IRA with after-tax dollars and don’t deduct your contributions when you file your tax returns. That’s good news and bad news, depending on how you look at it. The bad news is that you don’t get a tax break now. The good news is that you get a more valuable tax break down the road (aka after you turn 59 1/2). Why? Because you won’t have to pay income tax on either the money you originally contributed or the money you’ve earned over years in the market.
The younger you are, the more you stand to gain from opening a Roth as part of your retirement savings plan. Any money you contribute now will have more years of compounding and growth. That means you’re getting a bigger tax break when you start taking distributions in retirement than you would if you opened a Roth at age 50.
Another advantage of the Roth is that it doesn’t come with Required Minimum Distributions (RMD)s while the owner of the account is alive. That means you don’t have to start taking money out of your Roth IRA when you hit age 72 (because of Secure Act rule changes, those who reached age 70 1/2 in 2019 had to take first RMD by April 1, 2020), as you would with a traditional IRA.
Depending on your circumstances, the lack of RMDs could be a big advantage. If you’re already getting enough income from a combination of Social Security and a 401(k), having a regular IRA would require you to take distributions that could push you into a bigger tax bracket. With a Roth IRA, you won’t run into the problem of having to take money you don’t need only to be slammed with a bigger tax bill.
Weighing Other Pros and Cons
- While you can withdraw money that you contributed to a Roth IRA without taxes or a 10% penalty, you could end up paying both if you take out investment earnings before turning 59 1/2 or if the account is less than five years old.
- If you make an early withdrawal before 59 1/2, you will have to pay income taxes on the earnings, but you can avoid paying a 10% penalty as long as you withdraw the money for a specific need like investing in a first home, or paying for education expenses, and other qualifying exceptions.
- If you withdraw money at 59 1/2 or older, you can take out the earnings without owing taxes or a 10% penalty. However, if you owned the Roth IRA account for less than five years, you will still have to pay income tax but no penalty.
Roth IRA Eligibility
Roth IRAs were not designed for wealthy savers. In fact, there is an income cap on Roth IRA eligibility. The IRS income rules for Roth IRAs use your Adjusted Gross Income (AGI) as a guide. Your AGI is simply the total of all your taxable income, minus certain qualified deductions such as those for medical expenses and unreimbursed business expenses.
The IRS sets an income eligibility range that tells you whether you can make:
- the maximum contribution to a Roth IRA ($6,000 for tax years 2021 and 2022, $7,000 if you are age 50 or older),
- a partial contribution,
- no contribution.
For 2022, the AGI phase-out range for a married couple filing jointly is $204,000-$214,000. For those filing single, the range is $129,000 to $144,000.
If your income falls below the bottom of the range, you can contribute the full $6,000 to a Roth IRA. If it’s within the range, you are subject to contribution phase-out rules, meaning that you won’t be able to contribute the full $6,000. If your income is above the top of the phase-out range, IRS rules prohibit you from contributing to a Roth IRA.
The Backdoor Roth
If you are above the IRS income range, there’s a workaround called the “backdoor Roth” that will let you take advantage of Roth IRA tax benefits. So if you’re doing well financially, and have a 401(k) through your employer, this IRS-approved strategy can help you diversify your tax burden in retirement.
You should note that the Build Back Better bill proposed in 2021 to end backdoor Roth conversions. However, legislation has stalled with Senator Joe Manchin’s (D-WV) refusal to support the bill.
Under the current law, taxpayers in a high income bracket and already saving through a 401(k) at work, won’t be able to take a traditional IRA deduction. So if you file as single or head of household in 2022, and earn over $78,000, you won’t be able to claim a deduction. Those filing married jointly must earn less than $129,000, and taxpayers filing married separately cannot go over $10,000.
You can create a backdoor Roth by contributing first to a traditional IRA and then converting it to a Roth IRA. This will allow you to get around the contribution limits and avoid paying taxes on earnings.
Having a Roth IRA in your financial arsenal gives you more flexibility in retirement. You don’t have to take (and pay taxes on) Required Minimum Distributions if you don’t want to. And any money you do take out of your Roth IRA (that is a qualified distribution) is completely free from federal taxes?
If you are tempted to open a Roth IRA, it’s important to look for a provider offering low fees. Higher fees mean less money for you and more money for the financial institution hosting your investments. Fees can cost investors tens of thousands of dollars over the course of their working years, so it pays to shop around and get the best deal you can.
Tips for Getting Retirement Ready
- Industry experts say that people who work with a financial advisor are twice as likely to meet their retirement goals. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to set up and plan your retirement goals, SmartAsset’s retirement calculator can help you figure out how much you will need to save to retire comfortably.
- Another easy way to save for retirement is by taking advantage of employer 401(k) matching. SmartAsset’s 401(k) calculator can help you figure out how much you will have based on your annual contribution and your employer’s matches.
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