Roth Accounts Explained - The Questions Most Clients Have
History of Roth IRA's - The Roth IRA is a relatively new retirement vehicle, initially passed and supported by Senator William V. Roth Jr. (Hence the name), as part of the Taxpayer Relief Act of 1997, initially being available on January 1, 1998. The benefit to investors and savers was the ability to build tax-free investments that could be used to supplement retirement income.
- The Roth 401k was part of an Act in 2001 but made permanent under the Pension Protection Act of 2006
- The SECURE Act 2.0 of 2022 also opened Roth contributions to other Employer-Sponsored retirement plans such as SIMPLE IRAs and SEP IRAs
The In's and Out's of Roth Accounts - With Roth accounts of all types, the investor does NOT get a tax break when they contribute money, meaning it does not lower their income today, like a pre-tax contribution to a 401k, Traditional IRA or SIMPLE IRA would. The trade-off however is that when you take money out (including growth of funds) it is tax-free under certain stipulations.
- The account holder must be 59 1/2 years old to take out contributions, and growth, without incurring an Early Withdrawal Penalty.
- Additionally the account must be open 5 years as of January 1st of the first year you contribute money.
- Roth IRA's do have income limits (based on Adjusted Gross Income) that limit who can contribute normally to Roth IRA's, whereas Employer-Sponsored Plans such as 401k or 403b do NOT have income limitations.*
- Roth IRA's and Roth 401k's have NO Required Minimum Distributions (RMDs) at any age, meaning accounts can continue to grow as long as the investor is alive, without having to make withdrawals
Roth IRA's are one of the few retirement accounts that investors can still contribute to after age 70 1/2 as long as they have earned income.
What is better, a Roth IRA or Roth 401k? Like all things, it depends on your personal and financial situation. However there are cases where one may be better, or more advantageous than the other.
- A Roth IRA may be better for the following situations:
- When your income allows you to make the contribution normally (without the backdoor Roth conversion option).
- If you are already maxing out your retirement plan at work (401k, 403b, etc.) and want to fund extra long-term investment savings.
- You would like flexibility in your investment options, which are generally unlimited with IRA accounts and at the discretion of the investor and their risk tolerance.
- You would like flexibility in accessible money: Roth IRA's allow for more distribution options prior to age 59 1/2 which will be discussed below.
- A Roth 401k may be better for the following situations:
- You want to maximize retirement savings, with these having a much higher limit ($24,500 or $32,500 for those over 50) versus $7,500 or $8,600 in a Roth IRA
- You prefer to build more tax-free retirement savings for retirement and wish to diversify from taxable income (pre-tax contributions, pensions, etc.)
- Your income exceeds the limits to fund a Roth IRA
You have existing Traditional or Rollover IRA balances that prevent the ability to do Roth conversions with only after-tax contributions.
Here are some of the most unknown benefits to Roth accounts that my clients have asked me about -
- You can withdrawal your contributions at any time without penalty or tax.
If you contribute $7,000 to a Roth IRA this year, and say the account balance is worth $8,500 in two years. You can take out up to $7,000 without penalty or tax. However, be aware this is still counted as a non-qualified distribution if you're under 59 1/2 years old. The growth ($1,500 in this case) cannot be withdrawn under 59 1/2 without penalty, under normal circumstances. Additionally, up to $10,000 can be withdrawn one per lifetime for a first-time home purchase. Please review any distributions with your tax planning professional.
- Roth distributions are not counted as INCOME when taken (as qualified distributions).
- One very large advantage of Roth accounts, especially an IRA, is that when you take a qualified distribution in retirement that money is not counted as part of your income. For example, if you take $20,000 from a Roth IRA, have $30,000 in Social Security income and $10,000 from a pre-tax 401k - the $20,000 is not added to your total income for the year. Meaning, that you can effectively live on more money, and potentially have a lower taxable income.
- Roth IRA money can be used for college education.
- As mentioned above, your contributions can be taken out at anytime. Additionally, any growth of the account can be withdrawn (under age 59 1/2) to pay for qualified education expenses without the 10% early withdrawal penalty. The account also must meet the 5 year rule per the IRS. Another factor is that the growth may incur taxes as taxable income if under 59 1/2 years old. As an example - you have contributed $45,000 to a Roth IRA over 10 years, the Roth IRA is worth $85,000 ($40,000 growth). You could withdrawal up to $45,000 to pay for tuition and qualified education expenses without penalty, and up to the full $85,000 without a 10% early withdrawal penalty. Please consult with your tax profession if planning to use a Roth IRA for education.
I hope this is a helpful explanation of Roth accounts. Roth 401k's do have more limits to accessible money because of the inherit 401k rules that override the way contributions are made (Roth versus pre-tax). That is an important distinction in funding the right type of account given your needs and circumstances.
If you have any questions regarding Roth IRA's please do not hesitate to reach out to me. And stay tuned, for part two, where we discuss how Roth IRA's can be used in retirement planning! This will be a fun one.