Why is a ROTH IRA attractive to investors?
There are many vehicles to choose from as you travel the road to retirement. One of my personal favorites is the Roth IRA which can help build a tax-efficient nest egg for your future benefit. I want you to end 2021 strong, informed and well-positioned for whatever comes next for you. This month, I’m tackling frequently asked questions I’ve received about Roth IRAs.
Q: What is a Roth IRA?
A: A Roth IRA (IRA = Individual Retirement Account; not to be confused with a Traditional IRA) is a type of account that allows for after-tax (i.e.: “bank account money going into a retirement account”) contributions and in most scenarios - tax-free growth and tax-free withdrawals in the future.
Q: What about tax deductions?
A: While you don’t receive any current year tax deduction (as you might with a Traditional IRA), the Roth IRA allows for withdrawals that are not subject to federal income tax - when withdrawn after age 59½, so long as your account has been opened (“seasoned”) for at least five years.
Like a Traditional IRA, your interest, dividends, and capital gains are sheltered from federal taxes with a Roth IRA. Depending on state law, Roth IRA distributions may be subject to state taxes.
Q: Great! How much can I put into my Roth IRA for 2021?
A: Income limits may apply! Subject to income considerations, you may contribute up to $6,000 per year, plus for folks age 50 or older, an additional catch-up contribution of $1,000 is permitted.
Q: How and when can I contribute to my Roth IRA?
Assuming your income permits you to make contributions, you can contribute over the course of the year or as a lump-sum at any point during the calendar year and into the next year at least up until the tax filing deadline.
Q: I love my tax deduction on the Traditional IRA and the tax-free growth on the Roth IRA. Can I do both?
A: You may contribute a portion of the annual limit to your Roth IRA(s) and your Traditional IRA(s), however, you may not exceed the total annual limit between the accounts (or you’ll be doing some extra running around and paperwork to get that corrected and possibly create some tax issues for yourself).
Q: What’s the downside of a ROTH IRA?
A: The downsides (and these are relatively speaking as other account types may have other or additional downsides) may be: no tax deduction at the time of your contribution to the Roth IRA, the 5-year “seasoning” rule, low annual contribution limit, and not knowing for certain what tax brackets will look like at the time of withdrawing funds. If you’re in a lower tax bracket when you take distributions from your Roth IRA than when you made the contributions, the Roth IRA may not have been the optimal choice for you.
Q: What about RMDs? (Required Minimum Distributions)
A: In addition to tax-free withdrawals, Roth IRAs are not subjected to required minimum distributions at age 70.5 or age 72 (depending on your year of birth).
Q: What about my beneficiaries?
A: It depends. Under the SECURE Act of 2019, an inherited Roth IRA (and an inherited traditional IRA) must be distributed within 10 years when the beneficiary is not your spouse (in most cases).
Unlike a Traditional Inherited IRA, the inherited Roth IRA distributions are tax-free. This means one strategy your beneficiaries may want to consider is letting the inherited Roth IRA balance grow tax-free until year 10 and then doing the full account distribution at that time.
Q: I keep hearing about a “backdoor Roth”. What is it?
A: For those of you with a healthy six-figure income, income limits can create some issues contributing directly to a Roth IRA. However, there are some solutions and yes, they are legal. When income limits are an issue, one solution can be to make a non-deductible contribution to a Traditional IRA and then convert that balance to your Roth IRA in a timely manner.
Essentially, the “backdoor Roth” looks like a Roth Conversion: contribute to a non-deductible traditional IRA, open a Roth IRA (or use one you already have open), convert the contribution from the Traditional IRA into the Roth IRA and pay the taxes on any appreciation in that short period of time.
Conceptually, this is relatively straight-forward. However, if you have multiple Traditional IRA or other IRA balances, this can become a sticky-wicket and I mean fast! If you have other IRAs in your name, taxes are prorated! I won’t overwhelm you with details, but the bottom line is that it is really important to look at the whole picture before jumping into this strategy
As always, before considering a Roth IRA or backdoor Roth, consult with your trusted tax professional.
Q: What about mega backdoor Roth IRAs?
A: This is a great question. I’ll tackle this in a separate discussion to help from creating confusion as it isn’t a fit for everyone and really is a separate strategy. The short-answer for those who need a brief summary - a mega backdoor Roth is a way to move after-tax contributions from an employer’s plan (like a 401(k) for example) to a Roth IRA, even if their income limits are above the IRS limit for a Roth IRA contribution. Very exciting - stay tuned, more on this later.
Let me emphasize our goal of having open dialogue related to your financial needs and goals. Let’s have a conversation and get you where you want to be with more comfort, confidence, and fun.
Emily A. Secord, CFP®
Certified Financial Planner™
Info @ BrightFutureWealthManagement.com