Roth IRAs allow savers to set themselves up with tax-free retirement income. These after-tax retirement accounts were created 20 years ago by the Taxpayer Relief Act of 1997, and are named after Senator William Roth Jr. of Delaware, an advocate for the bill. Here’s a look at how to use a Roth IRA to improve your retirement finances:
Tax savings. Roth IRAs don’t give you a tax break in the year you make the contribution. Instead, Roth IRA deposits are made with after-tax dollars. However, the investment gains are not taxed each year, and withdrawals after age 59 1/2 from accounts at least 5 years old are often tax-free. “You pay the tax on the way in so you don’t have to pay the tax on the way out,” says Ed Slott, a certified public accountant and founder of Ed Slott and Company and irahelp.com.Read more ↓
While traditional IRAs allow you to defer paying income tax on your retirement savings, money contributed to Roth IRAs is taxed in the year you earned it, and account owners have an opportunity to avoid taxes on any of the investment gains. “If you are a young person who has many years for this account to grow and do well, at a certain point later on you can pull the money out tax-free,” says Michael Eisenberg, a certified public accountant and member of the AICPA’s National CPA Financial Literacy Commission. “Rather than taking the deduction now, it may be more beneficial to get income tax-free many years down the road.”
Contribution limits. Roth IRA contribution limits have increased from $2,000 in 1998 to $5,500 in 2018. Workers age 50 and older can make an additional $1,000 catch-up contribution for a maximum possible contribution of $6,500. You can contribute to a traditional and Roth IRA in the same year, as long as the contributions to both accounts don’t exceed the contribution limits. Married couples can save in a Roth IRA in each of their names, even if one spouse doesn’t work. However, you need earned income to contribute to a Roth IRA. If you only earn $3,000 in a year, that’s the maximum amount you could contribute to a Roth IRA. Also, be careful not to exceed these contribution limits. There is a 6 percent excise tax applied to Roth IRA excess contributions.
Eligibility limits. Eligibility to make a Roth IRA contribution phases out for individuals earning between $120,000 and $135,000 ($189,000 to $199,000 for couples). These income limits are typically adjusted for inflation each year. However, those with higher earnings might be able to get around the income limits by converting some or all of their traditional IRA savings to a Roth and paying the resulting tax bill. But be certain this is the move you want to make before initiating a Roth IRA conversion. The Tax Cuts and Jobs Act eliminated the ability to recharacterize, or undo, a rollover to a Roth IRA effective January 1, 2018. “In the past if you converted and you changed your mind, you weren’t locked into the tax bill,” Slott says. “Now, you better be sure, because if you convert the tax bill is due, and there is no going back.”
Contribution deadlines. Roth IRA contributions are due by your tax filing deadline in April. If you contribute between January and April, you will need to specify which tax year the contribution should be applied to. “When you make your investment, it’s absolutely critical that you notify whoever is making that deposit for you so that they clearly understand what year you are talking about,” Eisenberg says.
Lower penalties. If you need access to your money before retirement, the penalty for early withdrawals is less severe for Roth IRAs than traditional retirement accounts. Income tax and the early withdrawal penalty only apply to the portion of the distribution that comes from investment earnings. “Because you only get to spend what you don’t pay in taxes, having a good understanding of your overall tax situation is an important consideration,” says Eric Nelson, a chartered financial analyst and managing principal at Servo Wealth Management in Oklahoma City, Oklahoma. “And you need to think about this before you retire.”
No withdrawal requirements. While traditional IRAs and 401(k)s have annual withdrawal requirements after age 70 1/2, Roth IRAs do not require savers to take distributions in retirement. The money in a Roth IRA can continue to grow tax-free until you decide to spend it or your savings can be passed on to heirs. “If you are willing to give up the tax deduction up front that money will never be taxed again,” Slott says. “And if you never need it at all during your lifetime it can continue to grow tax-free and you can leave your tax-free Roth to your heirs.”