April 6, 2016

I recommend my clients use a Roth IRA to grow their retirement savings tax-free. Because I know the various types of IRAs can seem a little confusing, I thought I’d take some time today to answer the questions I get most often from clients.

What is a Roth IRA?

The Roth IRA is a type of individual retirement account that features tax-free withdrawals because the original contributions are made with after-tax money.

What’s the difference between a Roth IRA and traditional IRA?

There are several differences. The main one is when you pay taxes. With a traditional IRA, you invest pre-tax dollars and defer paying income tax until you take the distributions from the account during retirement. With a Roth, you pay income tax on the dollars you’re investing now—but when you take the distributions, they’re tax-free.

Other important differences have to do with the timing of your withdrawals. With either type of IRA, you need to wait until age 59 ½ to make withdrawals. But with a traditional IRA, you must begin making withdrawals at age 70 ½, or else you will face penalties. With a Roth, there is no required minimum distribution. If you don’t need the money in your Roth IRA when you’re 70 ½, you can leave it there to keep growing.

Am I eligible to set up and contribute to a Roth IRA?

In order to contribute to a Roth IRA for the 2015 tax year, you need to have taxable income for the year, and your adjusted gross income must be less than $183,000 if you are married filing jointly or $116,000 if you are single. (In addition, there’s a category in which you are allowed to contribute but your contribution limit is lower: for those married filing jointly whose AGI is between $183,000 and $193,000 or single with AGI between $116,000 and $131,000).

How much can I contribute to a Roth IRA?

In 2015, you can contribute up to $5,500 or up to $6,500 if you are 50 or older. If you are also contributing to a traditional IRA, then your total contributions to both IRA accounts may not exceed these same limits (so, for example, if you are under 50 and you put $2,500 into a traditional IRA, then you may only put $2,500 into a Roth IRA).

When can I set up a Roth IRA?

You can set up a Roth IRA at any time. You can make contributions for the previous year up to the date your taxes are due. For most people, then, you can make contributions for 2015 up until April 18, 2016. (This can be useful if you decide to set up a plan in January and want to make up time by, say, contributing 2015’s total early in 2016 and then making contributions throughout the year for 2016.)

Will I save more on my taxes with a Roth IRA or a traditional IRA?

Generally, you will have higher after-tax returns with a Roth IRA. One of the benefits of a Roth IRA that I haven’t mentioned is you effectively are able to put more after tax money into tax-deferral with a Roth IRA. For example, if you make a $5,500 contribution to a traditional IRA, you are investing $5,500 of pre-tax money in to a tax deferred account. If you took that same $5,500 of pre-tax money and invested in a Roth IRA, had the same investment experience and had the same tax rate at retirement that you have now, you would have an identical sum to the traditional IRA. However, because the $5,500 of pre-tax money is $3,960 of after-tax money (assuming a 28% tax rate,) you can effectively save $1,540 more after-tax with a Roth IRA.

One factor that can work against you in a Roth IRA is if you are currently in a high tax bracket and expect to be in a lower tax bracket in retirement. However, because of the advantages of higher after-tax investment and the no required distribution aspect of a Roth IRA, I generally think the Roth IRA is a good choice for most people.

What are Roth IRA Qualified Distributions?

Qualified Distributions from a Roth IRA are tax and penalty free. In order to be a qualified distribution, there are two requirements that must be met:

1. The distribution must occur at least five years after the Roth IRA was first established and funded; and,

2. One of the following requirements also must be met:

a. The Roth IRA owner must be at least age 59 1/2 years old,

b. Distributed assets limited to $10,000 are used towards the purchase of a first home for the Roth IRA holder or a qualified family member,

c. The Roth IRA owner is disabled; or,

d. The assets are distributed to the beneficiary of the Roth IRA owner after the owner’s death.

Distributions that do not meet the above criteria are considered non-qualified and may be subject to income tax and a 10% early distribution penalty.

Are there any other allowed early distributions from a Roth IRA?

In addition, the 10% early penalty is also waived for certain other distribution reasons.  But, for these distributions, taxes on any earnings will apply. The types of distributions that are subject to taxes on any earnings withdrawn but with no penalty include:

1. Substantially equal periodic payments,

2. Eligible medical expenses in excess of 7.5 percent of your adjusted gross income (AGI),

3. Medical insurance premiums for eligible unemployed individuals,

4. Qualified education expenses; and,

5. Distributions taken within the first five years for any of these reasons: age 59½, death, disability, or first-time home purchase.

Distributions taken for any reason other than a qualified reason or one of the reasons here are subject to both taxes and a 10 percent IRS penalty on any earnings withdrawn.

Are the investment options the same for Roth IRA as for traditional IRA?

Yes, just as with a traditional IRA, money inside a Roth IRA account can be invested in a wide range of securities, including stocks, bonds, and money market accounts. Your exact investment options will depend on the financial institution where you set up the Roth IRA account. We custody our clients’ Roth IRA accounts at Scottrade or Interactive Brokers because of there are no annual fees, discounted brokerage commissions, and strong investment platform with many investment options.

Can I leave my Roth IRA to my heirs?

Yes, and this is another area in which the Roth has some advantages; unlike with a traditional IRA, your heirs can keep the inherited money from a Roth IRA in the account beyond the time when you would have reached 70 ½. Since there are no required minimum distributions, you heirs will join the opportunity to compound their investment returns tax-free for a longer period of time than if you had a traditional IRA.

How Do I Open a Roth IRA Account?

We would be happy to help you open and invest in a Roth IRA account.  Please call us at (813) 282-7870 or send us an email, and we’ll help you open your Roth IRA account.

Did this answer your Roth IRA question?  If not, please ask us your question through our webform or email us and we respond promptly to your question.