Roth IRAs

By Jonathan G. Cameron, CFP® 

What is a Roth IRA?

One of the most popular ways to save for retirement is in a Roth Individual Retirement Account, or a Roth IRA. Roth IRAs first came out in 1997 after being championed by former Senator William V. Roth of Delaware. Tax-wise, a Roth IRA is basically like a Traditional IRA but backwards. In a Traditional IRA, just like 401ks, you generally get an up-front tax deduction when making a contribution. The account grows over time, tax-deferred. You don’t pay any taxes as the account grows. When it’s time to retire, whatever you take out of a Traditional IRA is taxable at your ordinary income rate.

Let’s do some basic math: if your tax bracket at retirement is 24% and you distribute $1000 from your Traditional IRA you will get to keep $760. The IRS keeps $240. Remember, since contributions are made before tax, distributions from a Traditional IRA are fully taxable.

The Roth IRA basically works the other way around. In a Roth IRA, or Roth 401k, you get no tax deductions up front when contributing. The growth within the Roth IRA is tax-deferred, just as in the traditional IRA. You can invest in stocks, bonds, mutual funds, exchange-traded funds (ETFs), and other investment vehicles. But when you retire and need income from a Roth, all your distributions — earnings plus contributions — come out tax-free!  Let’s do more simple math: assuming the same 24% tax bracket, and you distribute $1000 from your Roth IRA, you’ll receive back the same $1000 without a tax haircut from Uncle Sam.

This is the best deal out there!

If you’ve been saving money over several decade, think of how much of your hard-earned cash you’ll be able to keep just by proactively saving into a Roth IRA now. On the flip side, think of how much more you’ll need to save or earn within a Traditional IRA just to be able to access the same amount in retirement within a Roth IRA.

How much can I contribute?

You can contribute up to $6000 into a Roth this year (2020). If you’re over 50, the IRS lets you contribute an additional $1000, for a total of $7000. These contributions are after-tax, so you’ll get no tax deduction going in.

Your contributions can be withdrawn at any time with no taxable event. Earnings, however, are fully taxable and subject to a 10% penalty before age 59 ½. After that – the entire account can be distributed with no taxes. For Roth conversion amounts, there is a 5-year holding period rule, among other factors, so a Roth isn’t for short term investing.

Who should have one?

First let us ask another question: Do you think taxes will be higher or lower in the future? We’re guessing higher is a safe bet, right? This is the beauty of a Roth. A Roth IRA is best suited for those with a long time horizon. The younger you are the better. And it’s good for anyone who likes to pay less in taxes over the long term!

Who is eligible to contribute?

There are a few eligibility rules: First, you need to have earned income to participate – that is, taxable income that you earned in the current calendar year. Investment earnings and Social Security payments are not earned income in this context. Second, high earners cannot contribute to a Roth. If you make more than $124,000 as a single person and more than $196,000 as a married person (2020), you are subject to phaseout rules. Once your income exceeds phaseout limits, you can no longer contribute directly to a Roth. There are ways around this with Roth conversions, but that’s a topic we cover in another blog entry.

Why should I have a Roth?

For the huge potential tax savings!

I refer back to a point made earlier: you will, in theory, pay Uncle Sam significantly less to retire than if you saved exclusively in a Traditional IRA. I say “in theory” because if you keep Roth contributions in a money market or in short-term CDs, you will have very little earnings in the end. If you intend to be ultra-conservative in your long-term investment approach, you might as well take advantage of contribution tax deductions in the short term within a Traditional IRA.

The calculation you need to make is what's more valuable to you:  the tax deduction now on traditional IRA contributions or tax-free distributions at retirement?  So when investing for the future, do yourself a favor and choose the IRA registration that best meets your needs. Simple decisions early on, like contributing to a Roth IRA, can potentially save you hundreds of thousands of dollars in the long run. As CERTIFIED FINANCIAL PLANNER™ practitioners, this is exactly the kind of analysis we do on our client’s behalf.

If you like videos, watch Jonathan’s Roth IRA video.

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