I know, I know. You've heard a lot about Roth-type retirement accounts. But what the heck are they? What are the benefits? And are they really worth all the hype?
Let's take the last question first. The short answer is "YES, they are worth it." Roth accounts give you 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, will not only have significant benefits for your future life plans but also for near-term financial planning.
Roths provide opportunities to save for now and for the future. No matter how much you have saved up for your retirement, you can never plan with any degree of accuracy what the taxes will be when you start to withdraw the 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? Heck, yeah!
Let’s explore how you do that, because there are actually a few different ways to get there. We’ll cover five key points here.
- First off, remember that contributions to anything titled a Roth — whether it’s a 401(k), 403(b), Thrift Savings Plan (TSP), or Individal Retirement Account (IRA) — are always funded with after-tax dollars. In other words, your income will not be reduced by the contributions, as it is with ordinary retirement accounts. But whatever dollars your Roth fund earns will grow on a tax-free basis, as long as you meet certain requirements. Working with a financial planner will help identify the best path for you to take when considering a Roth.
- Most employer retirement plans — 401(k), 403(b), TSP — provide a Roth component, and this is the easiest way to fund a Roth. And guess what? You can elect to fund 100% of your contribution into the Roth account, or the pre-tax account, or both! As long as you don’t exceed the maximum for all contributions in the aggregate, you are good to go! In 2019, the maximum contribution levels are $19,000 for individuals aged 50 or younger and $25,000 for those over 50. For example, for those under age 50, one could elect to put $10,000 into the pre-tax side of their 401(k) plan and up to $9000 into the Roth side of the account. Your employer will match your total contribution with a contribution to the pre-tax side of your 401(k), regardless of how you have chosen to split your contributions.
- What about Roth IRAs? First, let’s cover the rules. Unlike the Roth versions of employer plans, there are some very specific rules to determine eligibility for funding a Roth IRA. In 2019, single filers with less than $122,000 MAGI (Modified Adjusted Gross Income) or those married filing jointly with less than $193,000 MAGI can fund a Roth directly and receive the maximum tax advantages. Roth IRAs offer account holders the ability to access their contributions at any time, regardless of their age or how long 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 your contributions at any time, the Roth IRA is 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.
- Do you 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 IRA if that they meet certain guidelines. If you choose this approach, you must not have any traditional/pre-tax IRA accounts currently open; that would invalidate the entire strategy. Here's what you do. First, open two IRA accounts, one as a traditional IRA and the other as a Roth. Next, fund the traditional IRA up to the maximum limits for after-tax contributions. Currently the maximum amount is $6,000 for individuals up to age 50 and $7,000 for those 50+. Wait a full day, and then move the traditional IRA funds into the Roth IRA. This strategy will be tax-neutral, since you funded it with after‑tax dollars in the first place. You can continue to do this each year and begin to build your tax-free bucket of income.
- Fewer age-based rules. With traditional IRAs, account holders are required to withdraw their funds at age 70½. Why, you ask? Because those funds have never been taxed: neither the contributions nor the earnings. With Roth IRAs, the contributions have already been taxed, so there is no mandatory requirement to withdraw funds. This means those dollars to continue to earn on a tax-free basis — either 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 95, you can continue to fund your Roth and enjoy the wonderful advantages of having a bucket of tax-free assets.
The bottom line is this: having some asset allocation in place for your investments is important. But the location of the asset is equally 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 ahead to fund and enjoy it.