Is a Roth IRA right for you?

Roth IRAs get a lot of attention in the media, particularly aimed toward younger investors in their early earning years. Roth IRAs provide an additional way to save for retirement with after-tax dollars, but how do you know if a Roth IRA is right for you? Consider the following.

Tax Advantages

Roth IRAs are funded with after-tax contributions, meaning that you contribute after-tax dollars today to avoid paying tax on the money when it is withdrawn in the future. Essentially, you are giving up the current tax deduction for the future tax-free benefit in retirement. Traditional IRAs are just the opposite – you receive a tax deduction today (assuming you are within the IRS-defined deductibility limitations), but then pay tax on the contributions and earnings when withdrawn in retirement.  If you expect your income to increase over time pushing you into a higher tax bracket when you retire (as demonstrated in the illustration below), or you have a long time horizon for the tax-free earnings to build substantially over time, a Roth IRA may be a good option for you.

Roth vs Traditional IRA

Withdrawals

Another thing that sets a Roth IRA apart from other retirement vehicles is the withdrawal flexibility. A Traditional IRA requires that a certain amount be withdrawn each year once the account owner reaches age 70½. Because tax has already been paid on the money contributed to a Roth IRA, the account owner is not required to pull money out in the future.

Because of this unique tax treatment, combined with the fact that Roth IRA owners will not pay income tax on a qualified distribution, a Roth IRA can be used for income tax diversification. In an effort to reduce your income tax liability in retirement, a Roth IRA could give you more flexibility to cover income needs in years you are in a higher income tax bracket (e.g. in a year you have a large required deferred compensation payout). If your retirement savings are 100% in a tax deferred employer plan or Traditional IRA, all money withdrawn from these accounts in retirement will be treated as income and taxed at your effective ordinary income tax rate. As seen in the chart above, Roth IRAs help slow the rate of portfolio depletion by keeping your tax liability lower in retirement if tax rates increase.

It’s easy to get sidetracked by what gives us the most benefit today, but equally important is the need to plan for flexibility in retirement. If you are early in your earning years, don’t get bogged down by prioritizing today’s taxes without considering the long-term benefit a Roth IRA may provide for you. If you expect your earnings to increase, now may be the perfect time to take advantage of a Roth IRA while you still can, and as your eligibility is phased out by income limitations over time, you may be able to take advantage of other options available to achieve income tax diversification, such as a Roth 401(k) (described below).

Limitations

As with any tax advantaged account, there are certain limitations. Refer to the chart below to determine if you are eligible to contribute to a Roth IRA in 2014.

Maximum contribution
  • 100% of earned income up to $5,500
  • $6,500 if eligible for catch-up contribution (age 50 or over)
  • Contribution maximums are in coordination with any contributions to a Traditional IRA
Roth contribution eligibility Income Limits
  • Single: up to $114,000 for full contribution; $129,000 for partial
  • Married Filing Joint: up to $181,000 for full contribution; $191,000 for partial

 

Alternative strategies

Roth 401(k)

If you don’t qualify to contribute because your income is above the limit, you may have another Roth option available to you inside your company retirement plan (e.g. 401(k)). While company plans are not required to offer a Roth option at this time, we have seen a growing number of employers add this as a feature to their existing retirement plans. This enables workers who are above the income thresholds to contribute a portion of their retirement savings to a Roth account within the retirement plan. Money contributed a Roth 401(k) account is taxed today, so you will lose the tax deduction associated with the traditional 401(k) contribution that you may be used to. However, if you still desire the tax deduction to reduce your current tax liability, consider splitting contributions between traditional and Roth in an effort to increase your income tax diversification. Keep in mind, a Roth 401(k) is separate and distinct from a Roth IRA, and is subject to separate rules. Contact your plan administrator or tax professional for more details.

Legacy Planning

If you have an existing Roth IRA that will likely not be needed for retirement funding, this can be a great vehicle for transferring money to heirs upon death due to the tax free treatment of distributions.  If the Roth IRA is small and you are unable to contribute to the account, you may never need to draw on the account for income needs in retirement. Consider investing this account for the long term with your beneficiaries in mind, as the distributions from the inherited Roth IRA will maintain the tax-free status for your heirs as well.

 

Overall, a Roth IRA can be an ideal retirement savings vehicle and a good place to start for those looking for tax advantaged savings beyond their employer’s retirement plan (if you fall within the income contribution thresholds, of course). Remember many rules, regulations, and proper coordination play a role when determining a proper strategy for retirement savings, and a Roth IRA may only be one piece of the puzzle. Talk with a financial professional about your goals so that you can determine a strategy that is best for you – one that prioritizes your needs and wants appropriately and takes your long term financial well-being into consideration.

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