I vividly remember the day when someone first used the term Roth IRA with me. The investment manager I was working for asked me to prepare paperwork to open a Roth IRA for his client. I had just started my job as an administrative assistant for a wealth management firm. I was 22 and had no idea what he was asking me to do. I didn’t know what a Roth IRA was, let alone how to open one; frankly, all I knew about money was that I needed it to pay my rent at the end of the month.
Fortunately, someone who worked at the company was willing to teach me how a Roth IRA worked, much the way I do with clients today. They aren’t innately complex but they offer significant tax benefits, so there are limitations to how and when they can be used. Let’s walk through the basics, the nuances and the potential changes that may be in forthcoming legislation.
What is a Roth IRA?
It is a special kind of Individual Retirement Account or bucket into which you place money for investing, typically for retirement. The contribution limit is $6,000 per year, which increases to $7,000 in the year you turn 50.
What is the difference between a Roth and a traditional IRA?
The most significant difference is the timing of when you get a tax break. Generally, you can take an immediate deduction for money you contribute to an IRA but not for the money you contribute to a Roth. The benefit of the Roth is that future qualified withdrawals are not taxed, while withdrawals from an IRA are taxed.
Roth TIP: Even the next generation can escape tax on Roth IRA withdrawals, making them a terrific asset to leave to your heirs.
Roths also differ in that you can withdrawal your contributions from a Roth IRA before age 59 ½ for any reason. With an IRA, you can access neither your contributions nor the growth before 59 ½ without paying tax and a 10% penalty.
A final difference is that Roth IRAs do not have required minimum distributions. IRA owners must take annual withdrawals from their IRAs starting at age 72. Roth IRA holders are never required to take distributions during their own lifetime.
Roth Trap: The most recently proposed version of the American Families Plan proposes required minimum distributions on investments including Roth IRAs if a taxpayer’s total retirement accounts exceed $10M dollars.
Why should you use a Roth IRA?
Money invested inside a Roth can grow significantly over time. Because you don’t have to pay taxes on qualified withdrawals, you permanently avoid paying tax on that growth. This benefit adds up: if you invest $10,000 a year for 20 years with an 8% return and your tax rate is 25%, you could wind up with $64,405 more by saving in a Roth versus a traditional IRA.
The tax savings on future growth and withdrawals can exceed the savings gained by deducting traditional IRA contributions.
Roth TIP: Roth IRAs are especially attractive if you are in a low tax bracket or have many years to let the Roth money grow.
Who can and can’t use one?
There are a few eligibility requirements:
You must have earned income, which includes wages, self-employment income, alimony, etc.
You must not earn too much income.
The income limit for singles is $125,000 to $135,000, with a partial contribution allowed if you fall in between the two numbers.
The income limit for married individuals who file joint tax returns is $198,000 to $208,000.
The income limit for married individuals filing separate returns is only $10,000.
Roth Trap: Be careful not to contribute too much to a Roth IRA especially if you are married and file separate returns.
You may contribute to both an IRA and a Roth in the same year but your total contributions can’t exceed the annual limit. So, $3,000 to each account is ok but $6,000 to each account is not.
There are no age restrictions for contributing to Roth IRAs.
Roth TIP: You can open a Roth IRA for your children and make contributions equal to the money that they earn working part-time. This a great way to help them start to invest.
What if you contribute when you shouldn’t have?
If you contributed too much to a Roth IRA, you have until the tax deadline in April of the following year to take out the excess contribution and any money you earned on it while it was invested. If you don’t take it out before then, you must report the excess contribution and pay a 6% tax on it every year until you take the money out.
Roth TIP: If you overcontributed to a Roth, you can “recharacterize” it as a traditional IRA contribution if you do it by the tax deadline.
How do Roth IRAs and Roth 401(k)s compare?
The accounts are taxed similarly. Neither type of account qualifies for an immediate tax deduction on contributions and both types of accounts escape future taxation on qualified withdrawals. The primary factor that makes Roth 401(k)s unique is that the contribution limit is over three times higher than that of a Roth IRA: $19,500 per year versus $6,000.
Roth Tip: You can contribute to a Roth 401(k) and an IRA (traditional or Roth) in the same year.
What investments are suited to a Roth IRA?
The investments inside your Roth should correspond with your overall investment strategy but to the extent that you own growth-oriented assets, like stocks, you might consider holding them inside your Roth IRA. Since growth that occurs in a Roth IRA can avoid future tax, it can be a great place to hold assets with a higher expected return.
Roth Trap: Reconsider holding conservative investments like cash and bonds in your Roth IRA.
What is the backdoor Roth method?
The backdoor or two-step Roth method is a way for high-income earners to circumvent the income limits for making Roth contributions. Oversimplified, the idea is to contribute to a traditional IRA without taking a tax deduction, followed by a tax-free Roth conversion to move the money from the IRA to the Roth. This is nuanced but works best if you don’t have any other money in traditional IRAs.
Roth Trap: The backdoor Roth method is set to be eliminated in the most recent version of the American Families Plan legislation. Roth conversions may be eliminated altogether for those in the highest tax bracket.
From serving as a starter investment for young people, a tax-favored retirement asset or a legacy asset to leave to your heirs, making good use of a Roth IRA can be an excellent way to build wealth. Steer clear of the traps and you are likely to find a way to fit a Roth IRA into your savings strategy.
As originally published on Forbes: https://www.forbes.com/sites/danielleseurkamp/2021/09/28/9-tips-and-traps-of-roth-iras/?sh=165767d26103