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Planning your Retirement: Understanding Roth IRAs and Their Unique Benefits

Over the course of your life and career, you have many options and avenues to save for retirement. These could be employer sponsored retirement plans, like a pension plan or 401(k), or an individual retirement account set up by you, more commonly referred to as an IRA. There are different types of IRAs:

  • Traditional IRA

  • Rollover IRA (a retirement account “rolled over” from an old job)

  • SEP IRA (Simplified Employee Pension Individual Retirement Arrangement – for self-employed persons)

  • Roth IRA.

Ideally, you will create a retirement planning portfolio that has a combination of retirement accounts. In this article, we will talk about Roth IRAs, which are unique from other traditional, rollover and SEP IRAs. With a Roth IRA, you contribute money that you’ve earned and already paid taxes on. When you access that money in retirement, all of your withdrawals will be tax-free.


One major touted benefit of retirement planning with traditional IRAs is the immediate tax benefit. If you contribute $3,000 to a traditional IRA, and have no retirement plan at work, you will receive an upfront tax benefit. If you have a 401(k) and also contribute to a traditional IRA, you may receive a tax benefit, depending on your filing status and your modified adjusted gross income. For those with employer sponsored retirement plans, you can see IRS contribution limits to a traditional IRA for 2019 here. IRA contribution limits for without an employer sponsored retirement plan are here. For those who qualify, a traditional IRA contribution makes saving for retirement less expensive in the short term, because contributions to a traditional IRA will lower your taxable income for the year you made the deduction. There is no tax deduction for upfront contributions to a Roth IRA.


Tax Free Income in Retirement


Roth IRAs allow you to save money now to create tax-free income in retirement. Every financial situation is unique, and no article can tell you what is best for your situation. In determining whether you should invest in Roth IRA or a traditional IRA, a financial advisor may ask you if you expect to have a higher or lower tax rate in retirement. If you expect to have a higher tax rate, contributing a Roth IRA may be more beneficial. The problem with estimating your financial situation in retirement is it may be difficult to estimate what this may look like in two, three, or four decades.


Typical of the government, lots of rules govern IRA contributions and withdrawals, which we will explore here in more detail. One important note, the Roth account must be designated as a Roth IRA when you open the account.


Eligibility Requirement


The IRS determines eligibility to contribute to a Roth IRA based on your modified adjusted gross income. If you are single, this amount must be under $137,000 (in 2019). If you are married filing jointly, this amount must be under $203,000. The IRS also complicates things further by having a phase-out, which reduces contribution limits starting at $193,000. Because the IRS changes amounts frequently, check the latest IRS Roth Contribution Rules at https://www.irs.gov/retirement-plans/roth-iras.

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The “Earned Income” Requirement


Earning money is a requirement to qualify for and contribute to a Roth IRA. This means you earned money for participating in a business. The IRS considers earned income to typically include salaries and bonuses, wages, tips, or sales commissions. Examples of money that is not earned income is income from rental property, child support, alimony, social security distributions or pension payments.


Roth IRAs Offer Flexibility for Early Withdrawals


While it is usually never advisable to tap into retirement funds early, Roth IRAs have a unique benefit. Because your contributions are from earned income that you already paid taxes on, you are allowed to withdraw your contributions if you need them, with no early distribution penalty or taxation on contributions. If you withdraw investment earnings, you may owe income taxes on those distributions. This flexibility makes Roth IRAs an attractive option if you may need to access contribution funds for college expenses, a home down payment, or any reason you need. This is in stark contrast to a traditional IRA, where you will pay a 10% early withdrawal penalty and tax on the distribution. Note that there is still a 10% penalty on withdrawing investment earnings, unless you have had the account at least 5 years and are at least 59½, disabled, have passed away (the distribution will be paid to your heirs) or using up to $10,000 of funds toward a first-home purchase.


No Required Minimum Distributions


If you have a traditional IRA, the IRS requires that you begin taking required minimum distributions (often called RMDs) at age 70 ½. Each year, the percentage of the balance that you must withdraw increases based on calculations of life expectancy. With a Roth IRA, there are no RMDs, because distributions are not taxable. You can keep the funds in the account as long as you like, and contribute at any age (as long as you earned income that year). If you leave an account for your heirs, it is a tax-free benefit for them.


How Much Can You Contribute to an IRA each year?


The IRS sets limits to how much you can contribute. For 2019, your total contributions to all of your traditional and Roth IRAs are limited to $6,000. If you’re age 50 or older, you can contribute up to $7,000. You can contribute to both a traditional IRA and a Roth IRA in the same year, so theoretically you can set aside some money for tax-free income in retirement, and also lower your taxable income by contributing to a traditional IRA.


Note: You cannot contribute more to a Roth IRA than you earned in income in any year. This is not a concern for most people with full-time jobs, but may apply to some people. Say you have a very part time job and earned only $2,000 over the course of the year, but have a lot of money in savings from an inheritance. You cannot use savings from your inheritance to contribute to a Roth IRA. In this scenario, you would be limited to contributing just $2,000 and no more.


Diversifying your Retirement


Famous business magnate Warren Buffett is famous for saying “Someone is sitting in the shade today because someone planted a tree a long time ago.” If you save as much money as you can now while you are working, you will have more financial security, and the flexibility to retire earlier, and sit in the shade. Whether your goals in retirement are to travel, spend time with family, or just get away from the pressures and stress of your job, saving as much as you can now will give you the flexibility to retire earlier later, and also have access to funds earlier if you need them. A Roth IRA is a valuable tool in a diversified retirement portfolio.


All information and materials in this article are for educational purposes only. Opinions expressed in this article are based on information considered reliable, but The Daily Money Show cannot guarantee the accuracy of the information nor should it be relied upon. The information discussed in this article should not be used as a recommendation to buy or sell securities nor should it be taken as investment advice. The Daily Money Show is not a Registered Investment Advisor or Broker Dealer. The Daily Money Show is not an accounting firm and does not give tax advice regarding any security or real estate transaction. You may want to consult with an accountant, attorney, real estate agent or financial advisor before proceeding with any transaction regarding securities or real estate.

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