Is a Roth IRA right for you?

Saturday, December 1, 2018 | MarketBeat Staff
Is a Roth IRA right for you?

There’s no debate about the importance of saving for one’s retirement. But how to fund a retirement is another question altogether. There are many products available to investors. One of the more recent offerings, relatively speaking, is the Roth IRA. The first Roth IRAs were offered as a provision of the Tax Relief Act of 1997. Roth IRAs have created a new option for investors, but it has also created a different model for thinking about their retirement account as it relates to their taxes.

The Roth IRA was the vision of a U.S. Senator from Delaware, William Roth Jr. as a way to combat the low savings rate in the country and make long-term investing more appealing, particularly to younger investors. From 2000-2016, money in Roth IRA accounts has grown from $77.6 billion to approximately $660 billion.

A Roth IRA shares some characteristics of traditional IRAs, but is mostly known, and appreciated for, its differences. In this article, we’ll break down what a Roth IRA is and detail how it is different from a traditional IRA.

What is a Roth IRA?

A Roth IRA is an individual retirement account with several unique features that separate it from other retirement plans. First, unlike other retirement accounts, contributions to a Roth IRA are not tax-deductible. This means that any money placed into a Roth IRA is done with after-tax dollars. This means investors will not realize an immediate tax benefit on money placed in a Roth IRA. However, the benefit of funding a Roth IRA with after-tax dollars is that the money coming out (i.e. earnings and withdrawals) are, with some exceptions, tax-free. And distributions from a Roth IRA do not contribute to an investor’s taxable earnings. An investor who anticipates being in a higher tax bracket when they will need to make withdrawals as opposed to where they are when they begin making contributions will benefit from the time value of money and the tax-free growth.

For example, an investor who puts $6,000 into a traditional IRA and is in the 25% tax bracket will be able to reduce their Adjusted Growth Income (AGI). However, when the time comes to withdraw the money, they will have to pay taxes at their current tax bracket, which may be significantly higher than the bracket that they were in. By contrast, if that investor contributes $6,000 to a Roth IRA, they would not be able to make any adjustments to their AGI, but when the time came to take a distribution, they would not have to pay a tax on the distribution. In both cases, the account will grow tax-free until a distribution is made. In the case of a Roth IRA, if the distribution does not take place until after the participant is past the age of 59 1/2, they will not have to pay any tax on the earnings.

Roth IRAs have income restrictions, no age restrictions

There is no age restriction for investing in a Roth IRA. This means that investors can continue to contribute to a Roth IRA well into their retirement. Investors who are contributing to a traditional retirement plan cannot make additional contributions after the age of 70 1/2.

However, although there are no age restrictions, a Roth IRA does provide income eligibility restrictions. For the tax year 2019, a single tax filer must have a modified adjusted gross income (MAGA) of less than $137,000 to make a Roth IRA contribution. At $122,000, contribution limits begin to be phased out. For married couples, the MAGA maximum is $203,000 with phase-outs starting at $193,000. 

You don’t have to take a withdrawal from a Roth IRA

One of the major differences, and benefits, of a Roth IRA, is that no withdrawals are required in the owner's lifetime. In a traditional IRA, investors are required to take mandatory withdrawals of a certain percentage of their funds when they reach the age of 70 1/2. These distributions are taxable upon withdrawal. Even if a taxpayer does not need the funds, they must take out a required minimum. With a Roth IRA, the money can stay in the account – and continue to benefit from compounding interest – throughout the owner’s life. And if a Roth IRA is passed along to a beneficiary, they can stretch out distributions over many years, and will still not have to pay income tax on the withdrawals.

Like a traditional IRA, investors that meet certain conditions can take qualified withdrawals of funds at age 59 1/2. To avoid triggering a tax event, the first withdrawal should not take place until five years after the first contribution. If that provision is met, then an investor will only have paid taxes on the money they contributed to their Roth IRA and not the money they took out.

If an investor needs to take money out of their Roth IRA prior to turning 59 1/2, there are provisions under which they can withdraw $10,000 of Roth earnings without penalty (provided at least five years have passed since their initial contribution) for first-time homebuyer expenses.

What type of investment options does a Roth IRA provide?

Another benefit of a Roth IRA is that the money inside of the account can be invested in a variety of investment options such as index funds, lifestyle funds, or individual stocks. The advantage of this is that investors can use a Roth IRA to achieve both diversification and asset allocation objectives.

Can other retirement accounts be converted to a Roth IRA?

Yes, investors can move funds that are in a non-Roth IRA into a Roth IRA. However, they must follow the conversion rules that are set out by the IRS. And funds that are put into a Roth IRA will trigger a tax event because it must be reported as earned income for the tax year when the conversion was made.

Roth IRA contributions may be eligible for a tax credit.

A little known potential benefit for lower income earners is the Roth IRA Saver’s Credit. If your adjusted gross income (AGI) is at or below certain threshold limits and you have a Roth IRA, you may be eligible to receive a tax credit that is a percentage of your Roth contributions that is determined by your AGI and filing status.

As of 2018, the threshold for filing status was as follows:

 Single - $27,750

Head of Household - $41,625

Married filing jointly - $55,500

Is a Roth IRA right for you?

Since Roth IRAs provide some significant tax advantages, the significant questions that need to be asked when deciding between a Roth IRA and a traditional IRA are if you will need the money and, if so, what tax bracket will you be in when you need it?

If you are viewing the money in your Roth IRA as money you may only need in an emergency or as funds you would like to pass along to heirs, then a Roth IRA makes a lot of sense because you will not be required to take distributions. However, if you do plan on taking distributions, you should focus on what tax bracket you will be in. If you are anticipating being in a higher tax bracket than when you started making contributions, a Roth IRA is an ideal choice because the after-tax money was put in at a lower tax bracket and you will not have any tax consequences for your withdrawal. On the other hand, if you are anticipating being in a lower tax bracket when you need the distributions, then a traditional IRA may be a good choice since you were able to defer the taxes when you made your contribution and will only be assessed at the lower tax rate when you make a withdrawal.

Another important question to think about regarding a Roth IRA is where does your retirement stack up with your other financial goals? Many younger investors, particularly young parents will have many savings priorities that may include such things as saving for a down payment on a home or putting money away for a child or children's college tuition. These are noble goals, but it can mean that they are not adequately funding their retirement. Because a Roth IRA allows the withdrawal of the contributions (not the earnings) before the age of 59 1/2, a Roth IRA can be used to help "double-dip" when it comes to meeting other financial goals. 

At the same time, a Roth IRA does allow catch-up contributions for investors over the age of 50. For some investors, this may be the time when the kids have left the nest and now that retirement goal is on the front burner. IRS regulations allow investors to put up to $1,000 above the $6,000 standard contribution into a Roth IRA. While catch-up contributions are also available to owners of a traditional retirement plan, it's important to know that this option still exists for investors who are in a Roth IRA.

Disadvantages to a Roth IRA

There are primarily three major disadvantages to a Roth IRA. The first is that the standard contribution for individuals to contribute is limited to $6,000. That makes it unlikely that a Roth IRA will be an investor's only retirement vehicle. A second disadvantage is that the income limits that are imposed on Roth IRAs mean that many individuals cannot make a full contribution. A third disadvantage is more psychological and that is that the government could remove the tax advantages of a Roth IRA and then all of the money that investors were hoping to accrue tax-free would now be subject to taxation.


The bottom line on a Roth IRA

There are some investors who swear by Roth IRAs and wouldn’t choose any other option for funding their retirement. One of the reasons for this is that a Roth IRA is funded by after-tax dollars. While this means that investors do not benefit from having pre-tax dollars used to fund their account like a traditional IRA, the use of after-tax dollars gives the Roth IRA several important benefits that are not possible with a traditional retirement account. Most notably:

  • The money they put into a Roth IRA can be withdrawn tax-free provided certain guidelines are met.
  • Withdrawals of contributions (not earnings) can occur for some life events before the age of 59 1/2 without penalty provided certain guidelines are met.
  • Investors do not have to take a withdrawal from a Roth IRA. This is different from a traditional retirement plan that requires a minimum withdrawal each year after the age of 70 1/2.

An additional benefit to a Roth IRA is that investors can continue to make contributions even after the age of 70 1/2. Other retirement plans not only require investors to stop making contributions at that time, but they require minimum withdrawals.

Although a Roth IRA may not be a vehicle to fully fund an investor’s retirement, and they may have some disadvantages, there are many reasons why a Roth IRA can be an important part of a balanced retirement plan. In fact, many advisors advocate for their clients having both traditional IRAs and Roth IRAs so that they can make withdrawals based on the current tax situation.

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