Do You Misunderstand Roth IRA Saving?


Many people casually throw around the terms Roth IRA and traditional IRA, but there are significant differences, with pros and cons to each. This article explains the value of a Roth IRA as a savings instrument.  

Roth IRAs, like traditional IRAs, can accumulate money faster than a comparable taxable investment, providing more money to live on during your retirement years. However, they do not offer the tax deduction that makes the traditional IRA a more-discussed option around the April 15 tax-filing date. At that time of year, many people are looking for ways to decrease their current taxes, so the topic of Roth IRAs fades in most tax-deduction conversations. However, focusing on short term tax savings can end up costing you more money in retirement because of higher taxes. When you withdraw the money, both your original savings and all its investment returns will be taxed at your income tax rate at that time. While future tax rates are unknown, it appears likely that tax rates will be higher in the future.  

Contributions you make to a Roth IRA are not deductible the way they are for a traditional IRA. However, you may be disappointed to find out what deductible means? All it means is that the dollar amount of your contribution is removed from your income for calculating your taxes in the year you make the contribution. It doesn’t mean that you never have to pay taxes on the money. (Some use the phrase pretax contributions as opposed to tax-deductible contributions to signal that the money will eventually be taxed.)

With a Roth IRA, you pay as if the money were simply coming out of your checking account, just as you pay your phone bill or make your car and mortgage payments.

When you recognize that contributing to a Roth IRA is like saving money right out of your checking account, you may be tempted to forgo saving in a Roth IRA. You may be even more tempted to do that when you consider that monies saved in a savings or brokerage account are taxed as long-term gains, and long-term capital gains are taxed based on your income at either 0%, 15% or 20%. Short-term gains, on the other hand, are taxed at your current income tax rate. If you save in a Roth and have short-term gains taxed at your marginal tax rate of, let’s say, 24%, that would reduce your gain on a dollar by $0.24.

Nevertheless, saving inside of a Roth increases your long-term accumulation, which will almost certainly be a plus come retirement time. And once you clear the five-year holding requirement and age 59 ½ hurdles (see below), you pay nothing on your gains. Another benefit of a Roth is that, if for some reason you need to access more money than your emergency reserves make possible, you can make withdrawals from your contributions without penalty. That’s because you have already paid taxes on the contributions. (If you want to access the gains prior to age 59 ½, however, you would be subject to penalties and taxes.)

This no-penalty feature on early withdrawals from contributions is not true of the traditional IRA. That’s why it’s important to consider when you will need to access money to determine where it should be saved. This is especially true if you want to retire prior to age 59 ½. In that case, you should have money saved in accounts that don’t penalize you for early withdrawals.

Two frequently asked questions

•            Do I qualify? The answer is yes if you have earned income for the tax year and your income is does not exceed the upper limit of the ranges below. If it exceeds the lower limit, your contribution will be reduced. If you are in between the limits, I recommend finding a professional to help with the calculations.

Single                                   $122,000–$137,000

Married filing jointly        $193,000–$203,000

Married filing separately $0–$10,000 

•            How much can I contribute? For tax year 2019, you can contribute up to $6,000 ($7,000 if you are over 50).

Five-year holding requirement for certain benefits

A few of the benefits of a Roth IRA don’t kick in until after you’ve been saving for five years. The five-year “clock” starts on January 1 of the year in which the first Roth IRA contribution is made. That means if you make the IRA contribution on April 15, it is treated as if you made it on January 1 for tax purposes, even though you didn’t get any earnings on your money between January 1 and April 15.

Once this five-year period begins, it counts not only for the initial contribution but also for all future contributions. The advantages that kick in after five years of saving include the first-time homeowner’s purchase mentioned below and the tax-free distributions to beneficiaries referenced in the Roth Advantages section.

Early-withdrawal penalty on earnings

Unless you qualify for an exception, any withdrawals of earnings, or gains, prior to age 59 ½ will be subject to a 10% early-withdrawal penalty. I refer to this as the retirement cookie jar penalty. Please note that this penalty is in addition to the tax due on the earnings. Here are the exceptions that exempt you from the early-withdrawal penalty on Roth IRA earnings:

·        death

·        disability

·        attainment of age 59½

·        substantially equal periodic payments

·        medical expenses in excess of 10% of adjusted gross income

·        first-time home purchase (up to $10,000) if you have met the five-year holding requirement

·        an unemployed individual’s purchase of health insurance

·        qualified higher education expenses

·        qualified reservist distribution

·        distribution due to an IRS levy of the qualified plan

These exceptions apply to individuals under the age of 59½ who withdraw earnings from their Roth IRA.

Roth Advantages

Along with featuring penalty-free withdrawals of contributions prior to age 59 ½, the Roth IRA might be advantageous for these reasons as well:

·        If you believe that the tax rates may change for the worse in the future: U.S. tax rates for middle- and upper-income earners are low right now when compared to the rates that prevailed in the 1960s and 1970s. Guessing tax rates is risky business, but when there is uncertainty, diversification can be a way to get you ready for all conditions. Why not have some money in both traditional and Roth IRA accounts?

·        If you want to shelter income and earnings from taxation after you reach age 70½: A Roth IRA lets you continue to save whereas a traditional IRA does not.

·        If you want to preserve your savings for beneficiaries and future generations: There are no minimum distribution requirements with Roth IRAs. Once the five-year holding period requirement has been met, beneficiaries of the account can receive tax-free distributions.

·        If you’re saving for a first home: The unique ability for first-time home buyers to take an early distribution without penalty makes the Roth IRA an attractive vehicle for accumulating a down payment. I believe this makes sense if the home ties into your retirement planning.

·        If you want to consolidate your IRAs: I’ll be writing at length in a later post about Roth conversions, but, for now, it’s good to know that Roth IRAs have the unique ability to accept “converted IRA” funds from both traditional and self-employment (SEP) IRAs with no time or income restrictions. You will have to pay taxes on the converted amounts, however. Conventional wisdom says the taxes should be paid from non-retirement accounts in order to benefit from a conversion. 

Roth 401(k) and Roth 403(b) to the rescue

Phased out of saving into a Roth IRA because your income exceeds the upper limit? Your 401(k) or 403(b) can now be amended to allow for Roth IRA-style deferrals. In fact, it may already have this feature. Such deferrals have two benefits over the Roth IRA:

1.           The annual contribution limit is higher. In 2019, $19,000 may be deferred to the plan under the Roth provision, plus an additional $6,000 if the participant is age 50 or older.

2.           Contributions under the Roth provision can be made by all participants, regardless of income.

This is the second article in a series about saving in a traditional IRA or Roth IRA and choosing the right one for you. I focused on traditional IRAs in the first article. I hope this article has helped you better understand the Roth IRA and its advantages in saving for retirement. In the next article, I will provide a comparison between the two types of IRAs.

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