It’s never too early to start your retirement planning. With that in mind, a Roth IRA might be just the thing for you. These are tax-advantaged retirement accounts that let you make contributions with money that’s already been taxed. Essentially, it’s a way of paying now to save later – because all future withdrawals are tax-free.
However, there are several factors to keep in mind, especially about limits and eligibility.
How Does a Roth IRA Work?
A Roth IRA is an individual retirement account that lets you make withdrawals when you’re 59½ or older (or you’ve had your Roth account for at least five years). The best part is, that these withdrawals are made without having to pay the tax man.
A Roth IRA offers several benefits, including:
- No restriction to contribution ages: you can contribute at any age, provided that you have a qualifying earned income.
- No mandatory withdrawals: you don’t need to take a minimum distribution amount.
- No income tax on inherited accounts: if you get a Roth account as part of an inheritance, you can continue making contributions without paying taxes.
How does a Roth IRA differ from a traditional IRA?
The main difference between Roth accounts and other IRAs is how they’re taxed. In a nutshell, choosing between them boils down to whether you want to pay taxes now, or defer them.
As mentioned above, Roth accounts are funded with post-tax income, so contributions are not tax deductible. In other words, you pay now to save later.
On the other hand, contributions to a traditional IRA may be tax-deductible, but they’re subject to income tax once you withdraw them. And although you might be able to make larger contributions to these accounts, as many employers will match worker payments to a 401(k), this still impacts your future tax liability. You see, you might save now, but you’ll pay for it later, by deferring your taxes. Keep in mind that how much tax you’ll pay also depends on your tax bracket.
How to choose between the two
If you suspect that you’ll be in a higher tax bracket when you retire, a Roth account might be a more attractive investment. After all, the amount of tax you’ll avoid in the future will probably outweigh the tax you pay on your contributions now.
Another aspect to consider when choosing between the two is your age. Because there’s no contribution or age limit to a Roth account, they are a good option for younger workers, or those with lower incomes. Even the smallest contributions can benefit from compound interest – and the longer your earnings can grow, the better.
And if for some reason you don’t want to withdraw anything from your Roth account on retirement, you can leave the account to your heirs as a tax-free inheritance.
Traditional IRAs, in contrast, are taxed on the distributions or withdrawals. This means the risk of the unknown, like what your tax bracket will be in the future, and the rate percentage at the time.
When it comes to making the choice, it’s best to chat with a CPA or tax professional.
Eligibility and Contribution Limits
Roth IRA eligibility depends on your Modified Adjusted Gross Income (MAGI), and your filing status. For the 2024 filing year, single filers under 50 years old who earn below $146,000 can contribute up to $7000 a year. If you’re over 50 in the same income bracket, you can contribute up to $8000. However, if you earn more than $161,000, you are not allowed to contribute to a Roth IRA.
Joint filers earning below a total of $230,000 can also contribute between $7000 and $8000 a year, depending on age. Unfortunately, if your combined income exceeds $240,000, you may not contribute to a Roth account.
Also, remember that you can’t contribute an amount exceeding your annual taxable income. For example, if you only earned $5000 this year, that’s the maximum amount you can contribute to your Roth account.
If you’re eligible for a Roth account based on income, you can fund it from a number of sources, such as regular contributions, spousal IRA contributions, transfers, rollover contributions, or conversions from a traditional IRA.
However, some funds are not eligible for Roth contributions. These include:
- Rental income.
- Interest.
- Income from pension or annuities.
- Contributions from securities or property.
- Stock dividends and capital gains.
- Passive income from a partnership.
Once your funds are contributed, you can decide how they should be invested.
Investment Options for Roth IRAs
Roth IRAs allow you to invest in many different vehicles. They include individual stocks and bonds, exchange-traded funds (ETFs), mutual funds, certificates of deposit (CDs), and money market funds.
This means that your return depends on your chosen investment. As such, it’s a good idea to invest in diverse options, in order to more easily manage risk and maximize your returns.
Withdrawal rules
It’s possible to withdraw from your Roth account at any time in the year, on the condition that you don’t take out more money than you contributed that year. But if you’re withdrawing more than that, remember that only ‘qualified’ withdrawals are exempt from tax.
Any non-qualified withdrawals mean that you’ll face a 10% early distribution penalty, or the funds could be subject to income tax.
Qualified withdrawals include purchasing your first home, some education expenses, health insurance payments if you’re unemployed, having a baby, or any expenses relating to having a disability.
How to Open and Fund a Roth IRA
If you want to open a Roth account, the first step is to choose a provider that has IRS approval. You can open the account at any time, but need to make all annual contributions by your tax filing deadline, which is usually April 15 of the next year.
When opening an account, you’ll be given an IRA disclosure statement, along with an adoption agreement and plan document. Together, these will explain all the terms and conditions, and outline everything you need to know about your investment.
Keep in mind that depending on where you open the account, fees and investment options may differ. As such, we recommend conducting extensive research to choose the perfect provider for your needs.
Strategies for maximizing Roth IRA benefits
There are several ways to build your Roth portfolio to maximize returns.
Consistency is key
Firstly, it’s important to make consistent contributions. Given the current maximum of $7000 or $8000 annually depending on your age, you can set up monthly transfers to reach this cap without breaking the bank.
This allows you to make the most of what’s called a ‘dollar-cost’ saving. In other words, by contributing and investing the same amount at set intervals, no matter the current share price of your investments, you manage risks through consistency.
Consider conversions
It’s possible to convert a traditional IRA to a Roth IRA to maximize the latter’s tax benefits. But before doing this, note that it’s considered a taxable event. In other words, converting your account means you’ll be taxed on everything in the traditional IRA that you want to put in a Roth account.
Once you convert funds, they need to be kept in the Roth IRA for five years before you make a withdrawal.
There are several ways to do a conversion. These include:
- Bracket-bumping (when you transfer only a portion of funds to move into or remain in a lower tax bracket).
- Market-timing (in which you wait for a market downturn before converting).
- Back-door conversion (where high-income earners can legally bypass the contribution limits).
For help deciding which strategy is best for you, and how to go about it, consider getting professional assistance.
Compliance and Reporting
Since Roth contributions aren’t tax-deductible, you will not need to report them on your return, unless you receive a non-qualified distribution. In this case, this should be reported on Form 8606.
However, depending on your contributions, you may also be eligible for a tax break called the Saver’s credit, which applies to low- and moderate-income taxpayers saving for retirement.
As such, it’s always advisable to keep detailed and accurate records of your Roth IRA contributions and related documents.
For advice on how best to maximize the returns on your Roth IRA, or for more information, schedule a Discovery Call with one of our CPAs.
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.
