I know, I know, you hear a lot about Roth accounts, whether they’re offered as an employee benefit or as Roth IRAs. What’s the big deal with Roth accounts anyway? And are they really worth all the hype?
The short answer is YES, because you have an opportunity to sock away money that will never be taxed when you take it out. That is H-U-G-E and a strategy that if put into place TODAY could will have huge implications for your ability to live life without being under the tax microscope. I can tell you that no matter how much you accumulate for your retirement years, one can ever plan with any degree of accuracy what the taxes will be when you begin to withdraw funds. Whether you’ve accumulated $50,000 or $5 Million, wouldn’t it be nice to know that you’ve got a tax-free bucket of funds that you can access? I thought so. Let’s explore how you do that, because there are actually a few ways to get there. For the purpose of this blog, we’ll cover 5 key points.
- First off, remember that contributions to anything titled as a Roth — whether it’s a 401(k), 403(b), TSP, or an IRA — are always funded with after-tax dollars. In other words, your income won’t be reduced by the contributions. BUT whatever those funds earn will grow on a tax-free basis.
- Most employer retirement plans (401(k)/403(b)/TSP) have a Roth component, and this really is the easiest way to fund a Roth. And guess what? You can elect to fund 100% into the Roth or the pre-tax side or both! As long as you don’t exceed the maximum contributions in the aggregate, you’re good to go! In 2018, the maximum contribution levels are $18,500 for individuals aged 50 or younger and $24,500 for those over 50. For example, you could elect to put $10,000 into the pre-tax side of your employer’s plan and up to $8,000 into the Roth side of the account.
- What about Roth IRAs? First, let’s cover the rules. Unlike Roth accounts offered through employer plans, there are some very specific rules to determine eligibility for funding a Roth IRA. In 2017, single filers with less than $118,000 MAGI (Modified Adjusted Gross Income) and married filing jointly with less than $186,000 MAGI can fund a Roth and receive the maximum tax advantages. Roth IRA accounts offer account holders the ability to access their contributions at any time — regardless of age or length of time the account has been open — and there are no taxes or penalties. The earnings grow tax-free and can be accessed beginning at age 59½, as long as the Roth IRA has been open for 5 years or more. Since you can access the contributions at any time, it’s a great way to save for retirement and for current lifestyle needs such as buying a house or a car or having funds available for that inevitable rainy day emergency.
- Make too much money to fund a Roth IRA? Take the back door. This strategy allows individuals whose income exceeds the annual limits to fund a Roth, provided that they meet certain guidelines. If you choose this approach, you must not have any traditional/pre-tax IRA accounts currently open; otherwise it will invalidate the entire strategy. First, open two IRA accounts, one as a traditional IRA and the other as a Roth. Next, fund a traditional IRA up to the maximum limits with after-tax dollars. Currently the maximum is $5,500 for individuals up to age 50 and $6,500 for over 50. Wait a day, and then convert the traditional IRA into the Roth IRA. This strategy will be tax-neutral, since you funded it with after-tax dollars to begin with. You can continue to do this each year and begin to build your tax-free bucket of income.
- Fewer age-based rules. With traditional IRA’s, account holders are required to withdraw funds at age 70½. Why, you ask? Because those funds have never been taxed: neither the contributions nor the earnings. With Roth IRAs, there is no mandatory requirement to withdraw funds, allowing those dollars to continue to earn on a tax-free basis, whether for you or for your beneficiaries. Also, you can continue to fund a Roth as long as you have wages, with no age restrictions. Whether you are age 72 or 82, you can continue to fund the Roth and enjoy the wonderful advantages of having a bucket of tax-free assets.
The bottom line is this: Having an asset allocation in place for your investments is important, but asset location is just as important, if not more so. Creating tax-free buckets of assets can be an integral part of your long-term lifestyle strategy. And the earlier you start, the bigger that bucket will be! But even if you are getting started a little later in life, you still have a lifetime to fund and enjoy it.