As an investment account that generates tax-free income, a Roth IRA is a foundational investment vehicle for anyone saving for retirement. Contributions can be withdrawn at any time without tax or penalty, while earnings become tax-free after you’ve held the account for at least five years and reached age 59½. Whether you’re just starting to save for retirement, or you’ve been investing for years, the reasons for making contributions to a Roth IRA are compelling.
For beginner investors just starting out
Your contributions to a traditional IRA or traditional 401 (k) are tax-deferred. You don’t pay taxes on that income today; you pay when you start making withdrawals in retirement. But who knows what tax brackets will look like in 30 or 40 years? A Roth IRA is your hedge. Building up your investment and the year-after-year tax-free growth is a huge win for you and your retirement. Currently, anyone making less than $150,000 ($236,000 for a couple filing their income taxes jointly) can contribute $7,000 annually to a Roth IRA.
The deadline for your annual contribution is April 15 of the following year, and the earlier in your career you start hitting those annual deadlines the better. You can’t go back and make up lost years of contributions, so it’s important to contribute the maximum allowable each year.
Generally, if you withdraw funds from a traditional IRA or 401(k) before age 59.5, you’ll pay a 10 percent penalty as well as taxes on the amount withdrawn. But no such limitations apply to a Roth, as you have already paid taxes on your contributions. You’re saving this money for retirement and ideally you don’t want to make early withdrawals, but if necessary and you follow the rules, you can withdraw up to the amount of your contributions at any time tax-free and without penalty.
The distinction between the plans grows even more substantial as you move through retirement. At age 73, you must start taking required minimum distributions (RMDs) taxed as ordinary income from a traditional IRA or 401(k). But that is not the case with a Roth. You have had the foresight to build up your retirement savings not only in a tax-free manner but in a way that gives you control over the funds and how and when you access them.
Participation in a Roth plan is particularly valuable for you as an employee of a business that offers an employer-sponsored Roth 401(k) that matches your contribution up to a certain amount with an employer contribution. That match used to be available only for a traditional 401(k), but as of December 2022 and SECRUE Act 2.0, employers can now make matching contributions to a Roth 401(k), making your tax-free bucket even more valuable.
A few other rules:
- You or your spouse must have earned income, that is wages, salary, or self-employment income to be able to make contributions. If you’re fully retired and not earning anymore, you are not allowed to contribute.
- The same rules apply to a Roth IRA you leave to the next generation. If passing money along to your heirs is important to you, the Roth IRA is a home run in terms of flexibility and tax efficiency. The beneficiaries have access to the funds tax-free with increased flexibility compared to other retirement accounts in terms of when and how they withdraw the funds.
- You can also contribute to a Roth on behalf of a child or grandchild who is working, up to the $7,000 limit or the amount of their earnings for that year if less than $7,000.
For higher earners further along in their retirement savings program
If you have advanced in your career, your annual income might put you outside the Roth contribution limits. As such, you will have to be more strategic with your Roth contributions by using a “backdoor” Roth IRA.
For a backdoor Roth, you contribute non-deductible funds to a regular IRA, then convert those funds to a Roth account. The same contribution limits as for a direct contribution apply, the advantages being that your funds grow tax-free and you enjoy the same Roth flexibility and tax-free withdrawals in retirement.
Both backdoor Roth conversions and Roth IRA accounts encourage you to invest strategically. You want to use investments with high growth potential or that are less tax-efficient. Equities with high growth potential, real estate investment trusts (REITs), and actively managed funds can create gains that are going to be yours to withdraw tax-free, whereas in a taxable account they’ll create more taxable capital gains. Those gains could move you into a higher tax bracket when you start making your taxable withdrawals, like your RMDs, and could also serve to increase your Medicare payments. Tax-efficient investments like municipal bonds, which are already tax-free, or low-growth investments like money market funds or fixed income positions are more appropriate for your traditional IRA where they will not create excessive gains.
We’re here to help. If you have questions about Roth IRAs or Roth 401(k)s, call me 814-836-5776, or email me at ggallagher@hbkswealth.com.
Important Disclosure:
The information included in this document is for general, informational purposes only. It does not contain any investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any investment advice. If you would like investment advice regarding your specific facts and circumstances, please contact a qualified financial advisor.
HBKS Wealth Advisors is not a legal or accounting firm, and does not render legal, accounting or tax advice. You should contact an attorney or CPA if you wish to receive legal, accounting or tax advice.
The historical and current information as to rules, laws, guidelines, or benefits contained in this document is a summary of information obtained from or prepared by other sources. It has not been independently verified but was obtained from sources believed to be reliable. HBKS Wealth Advisors does not guarantee the accuracy of this information and does not assume liability for any errors in information obtained from or prepared by these other sources.
Investment Advisory Services offered through HBK Sorce Advisory LLC, d.b.a. HBKS Wealth Advisors. Not FDIC Insured – Not Bank Guaranteed – May Lose Value, Including Loss of Principal – Not Insured By Any State or Federal Agency.
