Should I Invest in a Roth IRA?

I often get asked from clients if they should open a Roth IRA or use the Roth option in their company’s 401K plan. The answer is typically yes, but there are a lot of considerations to think through. Let’s first start by just distinguishing the traditional IRA and its contributions from the Roth IRA and its contributions - the differences are all tied to income taxes. We’ll then highlight some of the other benefits of why you may want to consider using a Roth IRA in your investment portfolio.

Traditional IRA contributions are made pre-tax. What does that mean? It means your contributions today reduce your taxable income today. For example, if you contribute $6,000 to your IRA, your taxes might be reduced by $1,200, depending on your tax rates. These types of investments are very helpful for investors with higher earnings and many two wage households who are seeking to reduce current taxes. The earnings on your IRA grow tax-deferred, until you withdraw money from your account in retirement, after age 59 1/2. Your distributions, in retirement, then are taxable. The theory is you reduce taxable income today while you’re working and are in a higher tax bracket. When you draw the funds when you are no longer working in retirement you will generally be in a lower tax bracket. If you haven’t withdrawn anything from your IRA, the government will require you to start when you reach age 72 (or age 70 ½ for those achieving it before Jan. 1, 2020) with a Required Minimum Distribution (RMD). This RMD amount is calculated based on the balance of the IRA at the beginning of the year divided by the investor’s life expectancy factor as determined by the IRS. The RMD amount must be distributed, and taxes paid on it each year, or investors face a severe penalty.

By contrast, Roth IRA contributions are made after tax so there is no reduction to your taxable income today. If you contribute $6,000 to a Roth IRA, those will be after-tax dollars. The big deal about Roth IRAs is the earnings grow tax free until you retire and beyond. That means when you draw out those funds in retirement you don’t have to pay tax on that money. This can give retirees a nice income stream with no impact to taxable income or tax brackets. Because there are no taxes due, the IRS also doesn’t require you to take an RMD, giving investors flexibility.

There is no difference in contribution limits for IRAs, which are both limited by IRS rules. For 2021 contributions are limited to the greater of $6,000 or earned income for those under 50. For investors over age 50, contributions are extended to the greater of $7,000 or earned income. For those of you who may want to contribute to both traditional and Roth IRAs, the limit is still a combined $6,000 for those under 50 and $7,000 for those 50 or over. There are also income limits for both traditional and Roth IRA contributions. For traditional IRAs, the limit determines whether the contribution is tax deductible and applies to investors who are covered under a retirement plan at work. For single taxpayers who are covered by a plan at work and have modified adjusted gross income (MAGI) greater than $66,000 per year, traditional IRA deductions may not be tax deductible. The same for married taxpayers covered by a plan at work when the MAGI is greater than $105,000. If your spouse is covered by a plan at work, though, and you are not, the income limit rises to $198,000 in MAGI though. Roth IRA’s also have income limitations. To contribute the full amount to a Roth IRA, single investors must have MAGI less than $140,000 and married investors must have MAGI less than $208,000.

Besides the benefit of tax-free income in retirement, there are a couple of other benefits to investing in a Roth IRA now. First, because your contributions are funded with after-tax dollars, your contributions can be drawn out at any time without paying a penalty. Just to be clear, that’s for your contributions and not any earnings on those contributions – those have to wait until retirement or another exception. Second, investors who are buying a home or paying for qualified education expenses may withdraw tax free from both contributions and earnings, within some limitations. This makes it a little more flexible retirement saving vehicle than a traditional IRA

So, who should invest in a Roth IRA? For sure, it makes sense for young people – students and young professionals – whose income tax rates are likely lower now, to invest in a Roth IRA. First and foremost, they have a long time until retirement for those balances to grow tax free. Additionally, they are often already in lower tax brackets, so there’s not as much tax benefit for them in pre-tax contributions. Second, it’s less likely that these younger people will exceed the Roth IRA income limits discussed previously.

Another group we’re seeing get in on the Roth IRA benefits are retirees. Some are choosing to convert funds from traditional IRAs to Roth IRAs and paying the current period tax. The Roth IRA balance then grows tax free. One benefit of this is an ability to create tax free inheritance for their spouse or heirs. For a spouse, they can keep the Roth IRA growing tax-free as long as they choose. But even non-spouse beneficiaries of a Roth IRA would have up to 10 years to withdraw all the funds out of the inherited Roth IRA, as long as the Roth IRA has been open for at least five years. That’s ten more years of tax-free growth.

One more consideration before we go. If you are still working and your employer offers a Roth option within your 401K retirement plan, it’s a great idea to check that out. Roth 401Ks allow an investor to contribute more per year. In 2021 both traditional and Roth 401Ks allow contributions of up to $19,500 per year, or, for investors over 50 up to $26,000 per year. The other significant benefit of Roth 401K contributions is there is no income limit. So even higher income investors can contribute into a Roth 401K if they choose.

As we’ve said previously, the most important thing you can do for retirement is to start saving early. If you would like to have discussion on what options may work best for you in your situation, please don’t hesitate to reach out to your advisor.