Roth IRAs are often touted as a great retirement planning tool. But what do they really do for you? And how do you invest in one?
Roth IRAs are not a specific investment or fund, but instead a type of account. The specific investment is likely some type of mutual fund, ETF, or stock / bond portfolio. The Roth decision creates an account with a unique tax structure, where contributions to the account are NOT tax-deductible now, but assuming you wait until age 59.5, distributions (including gains) are tax-free. This is the reverse of the Traditional IRA, where you take a deduction now, but any future distributions are fully taxable as ordinary income. So, simply stated, assuming all requirements are met, the key difference is you pay tax now on a Roth, and later on an IRA (tax deferral).
Wait, so I don’t get a tax break now? Why would I want to pay taxes sooner rather than later?
Glad you asked! Roth accounts aren’t appropriate for everyone, so you’ll have to make that determination with your financial advisor and tax professional. However, there are a few key factors that influence this decision:
- Age – As the account has more time to grow before you need the money back out, the value of the Roth’s tax-free benefit increases over the IRA’s tax-deferral.
- Current vs Future Marginal Tax Rate – If you are in a high tax bracket now, it might not make as much sense to fund a Roth, unless you expect to still be in a relatively high tax bracket when it comes time to take the money back out. If you expect tax rates to be close to or higher than they are today, a Roth becomes a very valuable tool.
- Investment Return – The more you expect to earn on the account, the better the benefit for the Roth account over the Traditional IRA.
You can see the impact of changing these variables using an online calculator such as this one.
This might be useful for me in my current situation. Are there limits on what I can put in?
Of course there are! As with many great planning tools, there is a limit on how much we can use them. The IRS (currently for 2016 and 2017) limits your Roth IRA contribution to $5,500 per year, or $6,500 per year if you are over age 50.
There is also an income limit, where if you are filing single, your Roth IRA contribution eligibility is phased out from $117,000 to $132,000. If married filing jointly, the phase-out is from $184,000 to $194,000. These numbers have each been indexed up by $1,000 for the 2017 phase-outs.
What about the Roth 401(k)? Is that the same thing as a Roth IRA?
Great question – you seem to know more about this than you let on! The Roth 401(k) is a provision that your employer may or may not have in their retirement plan. If it’s available, this allows you to choose between Traditional and Roth options (or a mix of both) for your deferrals. The tax treatment will be the same, but it has a few key benefits.
First, there is no income limit that prevents you from making the 401(k) deferrals, and second, the dollar contribution limit is much higher. Inside the 401k you can defer up to $18,000 a year, or $24,000 if you’re over 50. You can split this between the two types, but be aware that any employer match will always go to the Traditional account.
What if I have an IRA already? Is there a way to switch it over to a Roth? If so, how do I know if I should?
Sure thing! If you want to pay more money in taxes now, the IRS will gladly let you! This process is called a Roth Conversion, and it involves transferring the funds from the IRA to the Roth IRA. At the end of the year you’ll get a 1099 for this, and owe ordinary income tax on your conversion amount.
Back in 2010, the income limit to perform this conversion was removed, so even if you are a high income earner, you can still convert your Roth if it makes sense for your situation. So how do you know if it’s the right move for you? Well, that’s another discussion for you to have with your financial advisor and tax professional, but it goes back to the same factors as before – time, investment returns, and tax rates are key for evaluating this decision.
One item to note is that if you run the numbers, and decide to do the conversion, you need to be prepared to pay that tax out of pocket, because taking it out of the IRA would be an early withdrawal subject to tax and a penalty. The tax bill won’t be due until you file the return for the year of conversion, but if you end up owing a significant amount on your tax return, you might end up with a penalty there, so you’ll want to consider making adjustments to your withholding or otherwise covering this tax bill early.
What if I make too much money to qualify for a Roth IRA?
Congratulations on your hard work! You’ve been rewarded with a restriction on the standard Roth IRA contributions. However, there are a few ways you can still participate. The first is if your employer has a Roth 401(k), or if you own your own company, you can set one up for yourself and your employees. The second is through a tax loophole known as the “backdoor Roth.”
What the heck is a Backdoor Roth? And did you say loophole? Sounds shady.
Thanks for your concern! However, it’s not shady at all. The backdoor Roth is a well-established process where the high-income earner makes a contribution to a Traditional IRA. Since earnings would be above the limits to deduct this contribution, it’s called a non-deductible contribution. The IRA is then immediately converted over to a Roth. Since the IRA has a tax basis of the non-deductible contribution, there won’t be any tax due on the conversion. So the net process is the same, but you have to jump through a few hoops to get there.
When the conversion calculations are performed on the tax return, any basis inside the IRA is allocated pro-rata. If you started with a $5,000 non-deductible contribution, and that’s your only IRA account, then there will be no tax owed on the conversion, because your basis fully covers the value you are converting.
However, one very important item is that if you do have another IRA account, this is included in the calculation. So let’s say you currently have a $10,000 IRA, and you want to do a backdoor Roth for $5,000. You add the non-deductible $5,000 to the IRA, which is now $15,000 with a basis of $5,000. If you convert $5,000 to a Roth, you’ll actually report ordinary income on 2/3 ($10,000 / $15,000) of your conversion. That is, the pro-rata rules prevent you from identifying which $5,000 you are converting. Note that this rule only applies to IRA assets; a 401k balance won’t affect these calculations.
So the backdoor Roth and its long-term tax benefits could actually incentivize you to convert the whole IRA now, even if you are in a high tax bracket, especially if you plan to fund the backdoor Roth every year and have a long time for it to grow.
OK, that sounded really complicated, but I think I get it. Is there anything else I’m missing that I should know about before I dig into this any further?
Well, I think we’ve covered the key items, but there are a few other rules to know. One is that, if necessary, you can always get back your contributions to the Roth IRA, tax and penalty free. Distributions come out as basis first, so since it is money you already paid tax on, there’s no penalty to get that back out.
If you get into the earnings portion, you will owe tax and a penalty unless you meet one of a few exceptions. If you try and tap your Traditional IRA early, you’ll have taxes and a penalty on the entire amount of the withdrawal. So while it’s not an ideal scenario, a Roth can provide some emergency liquidity if the situation arises.
One other item is that there are no required distributions later on in life, because the IRS won’t force you to take money out if there’s no tax revenue in it for them. Also, you do need to have earned income, unless you qualify for a spousal IRA.
Finally, I can’t stress enough that you should discuss this all with a financial advisor who can help determine what retirement tools are best for you.
Nick Mengel is a Certified Financial Planner™ practitioner and provides financial planning and investment analysis for MSMF’s partners and clients, as well as for his own personal clients. He has a Masters in Finance from Washington University – St. Louis and more than 10 years of industry experience. In his spare time, Nick enjoys outdoor activities, sporting events, and motorcycle riding.