When investing for retirement outside of a 401(k) or other employer-sponsored qualified plan, individual retirement accounts are common choices because of their tax savings opportunities. In considering additional retirement investment options such as IRAs, many individuals look to the Roth IRA option. So much of the decision on whether to go with a Roth IRA depends on your income tax planning strategy. Many people who choose the Roth IRA route over that of a traditional IRA hope to use incentives such as the power of tax-free compound interest to break even with their tax payments over time. But does a Roth IRA really provide enough incentives to make upfront tax payments worth it? Below are five rules to consider in deciding what retirement plan is right for you.
1. Don’t get a Roth IRA unless you expect your tax rate to be higher at retirement than your current rate
Unlike traditional IRAs, Roth IRAs are unique retirement accounts in that you pay taxes on money going into your account, resulting in all future withdrawals being tax-free. This can be a convenient option for young people with lower incomes who are expecting to be in a higher tax bracket in the future, and are looking to benefit from years of tax-free, compounded growth. However, negatives such as the fact that there is no upfront tax deduction for Roth IRA contributions, and that there is no telling what today’s tax brackets will look like in the future, should be considered carefully in determining which type of IRA is right for you.
Of course, it is difficult to predict whether you will be subject to higher taxes in the future. Here it is important to ask yourself a few questions. What tax bracket are you in today? What tax bracket do you expect to be in when you retire? How will inflation effect the value of money now versus in the future? With inflation on the rise, it is quite possible that a higher future tax bracket could still amount to less value expended on taxes in the future, as the value of the dollar is continuously shrinking. And even in the event that you do predict overall savings by paying taxes now, you should still ask yourself what the value of a dollar is to you today versus in the future. It is quite possible that you could make better use out of that dollar today, while you are young and trying to make it, than in the future when you are happily retired and financially stable.
2. Roth IRA contributions can be withdrawn at any time, tax-free and penalty-free
With Roth IRAs, contributions can be withdrawn at any time, tax-free and penalty free, as long as your Roth IRA has been open for at least 5 years. This means that you can withdrawal the exact amount of your total Roth IRA contributions at any time after 5 years with no penalties. Whereas with traditional IRAs, withdrawals are not penalty free until you reach the age of 59 1/2. Note that if you choose to withdraw the amount you’ve contributed penalty-free and tax-free before the age of 59 1/2, you have to have proof of how much you’ve contributed over the years. This makes it important for Roth IRA investors to maintain careful logs of their contributions, so that in the event of withdrawal before age 59 1/2, they know what’s taxable and what isn’t. This means that Roth IRA investors should keep their old Forms 5498. These are the forms that the IRA custodian sends to the IRS each year that an IRA contribution is made. You should receive a copy.
And the documentation requirements don’t end there. When you pull money out of your contribution base, the IRA custodian will send a Form 1099R to the IRS, and the IRS will assume it’s taxable. You then have to fill out a Form 8606 and attach it to your tax return for the following year. This form will state your Roth distribution amount and net it against your Roth distribution basis, resulting in a calculation that proves whether any of the distribution is taxable and subject to the 10% penalty.
Note that traditional IRA money converted into a Roth IRA account is also considered basis, which should be added to your Roth contribution base. The IRS considers withdrawals from your Roth IRA in this order: your contributions first, then money converted from traditional IRAs, and lastly, investment earnings. For example, if your Roth IRA has $10,000 in it, $5,000 of which is from contributions and $5,000 of which is from investment earnings, and you withdraw $6,000, the IRS will consider $5,000 of that to be contributions and $1,000 to be earnings. So any penalty would apply only to the $1,000.
If, within the 5-year period starting with the first day of the tax year in which an amount from a traditional IRA is converted, or an amount from a qualified retirement plan is rolled over, a distribution is made from a Roth IRA, the Roth investor may have to pay the 10% additional tax on early distributions. Generally, a Roth IRA investor must pay the 10% additional tax on any amount attributable to the portion of the amount converted or rolled over and included in income, because a separate 5-year period applies to each conversion and rollover. For example, imagine that a calendar-year taxpayer makes a conversion contribution on January 20, 2015, and makes a regular contribution for 2014 on the same date. The 5-year period for the conversion would begin on January 1, 2015, while the 5-year period for the regular contribution would begin on January 1, 2014.
Finally, it is important to keep in mind that you’re losing tax-free compounding on the amount you withdraw. You can’t replace the money in the account. But you can start anew with future annual contributions.
3. Roth IRAs have income limits
Generally, according to the IRS website, for 2016 you can contribute to a Roth IRA if you have taxable compensation and your modified AGI is less than:
- $194,000 for those that are married filing jointly or qualifying widow or widower
- $132,000 for taxpayers who file as single, head of household, or married filing separately
- $10,000 for those who are married filing separately and you lived with your spouse at any point throughout the year
Taxable compensation is defined by the IRS to include “wages, salaries, tips, professional fees, bonuses, and other amounts received for providing personal services. It also includes commissions, self-employment income, nontaxable combat pay, military differential pay, and taxable alimony and separate maintenance payments.”
When looking at your modified adjusted gross income (AGI) for Roth IRA purposes, it is your AGI as shown on your return with the following adjustments–traditional IRA deductions; student loan interest; tuition and fees; domestic production activities; foreign earned income exclusions and housing exclusions; as well as foreign housing deductions, excludable qualified savings bond interest, and excluded employer-provided adoption benefits.
4. Earnings rules for Roth IRAs aren’t much better than with traditional IRAs
Given the fact that a Roth IRA investor pays tax upfront on contributions, one might think that there were incentives associated with the treatment of Roth IRA earnings versus earnings by holders of traditional IRAs. However, this is not really the case. In fact, Roth IRA earnings generally cannot be withdrawn penalty- or tax-free at anytime. This rule solely applies to Roth IRA contributions.
However, there are withdrawal provisions that allow a Roth IRA investor to access his or her investment gains early without a penalty. For example, there are certain exceptions for withdrawals used to purchase your first home or to cover postsecondary education expenses. However, even the exceptions do not provide much additional relief when compared to traditional IRAs. For example, the first home purchase exception provides that after 5 years, up to $10,000 in earnings can be withdrawn penalty-free to cover first-time home buyer expenses. But this same benefit is also provided by traditional IRAs, the only difference being that taxes are due on distributions of earnings from traditional IRAs. This qualification is rather obvious, considering the paramount difference between traditional and Roth IRAs is taxes being due upfront versus in the future. Additionally, the traditional IRA holder arguably comes out ahead in this scenario, as his or her original contributions lowered his or her AGI, potentially qualifying him or her for other tax deductions and incentives upfront.
5. Roth IRAs don’t require distributions at certain ages
Also, with Roth IRAs, no withdrawals are required during the account holder’s lifetime, so beneficiaries can stretch distributions over many years, whereas with traditional IRAs, distributions must begin at age 70 1/2. The fact that a Roth IRA investor never has to withdrawal funds makes it extremely attractive to individuals looking to build an inheritance. In this regard, a Roth IRA might be a favorable inheritance alternative to putting money away in a trust.
In choosing a retirement savings plan that is right for you, it is important to look into the pros and cons of all investment options. While the benefits of Roth IRAs are there, it is important to keep in mind the administrative burdens attendant to receiving Roth IRA tax incentives. After a little digging, you might find that all of the rules surrounding Roth IRAs can make them a less attractive investment choice than alternative options. It all really depends on your current financial status, as well as your financial goals for the future.
If you have any questions about topics discussed in this article, please feel free to contact the author, Aveed Majd, at email@example.com.