There’s a lot to like about investing in a Roth IRA, Roth 401(k) or Roth 403(b), especially if you’re young or expect to be in the same (or higher) income tax bracket when you retire. Any money you invest in a Roth grows tax-free—even when you cash out in retirement—and it can be invested in a number of ways, from stocks and bonds to mutual funds. Another plus: the 2018 Tax Cuts and Jobs Act (TCJA), makes Roth IRAs even more attractive because they can protect your investment from future tax rate increases.
Roth IRA vs. Traditional IRA
You may already be familiar with a traditional IRA. The primary difference between a Roth IRA and a traditional IRA is when you pay taxes on your contributions (the amount of money you’re investing). With a Roth IRA, you pay taxes upfront, when you make a contribution; with a traditional IRA, you pay taxes later, when you withdraw funds.
- Income limits. Almost anyone with earned income can contribute to a traditional IRA. There are income limits for contributing to a Roth.
For the 2018 tax year, if you’re filing taxes as an individual, your annual Roth contribution is phased out between modified adjusted gross income (MAGI) of $120,000 and $135,000. If you’re married and filing jointly, the phase-out range is between MAGI of $189,000 and $199,000. In 2019, the phase-out range for individuals is between $122,000 and $137,000; for married couples, it’s $193,000 to $203,000.
The maximum amount you can contribute to a Roth IRA during the tax year is the lesser of your earned income or annual contribution limit. If you’re married, you can add your spouse’s earned income to the total.
- Contributions. If you’re younger and in a lower tax bracket, a Roth IRA could enable you to access some of your money later without penalties. Some married couples might also consider funding a spousal Roth IRA. You need earned income to contribute but for married couples, there’s an exception for a stay-at-home spouse.
If you believe you’ll pay the same—or higher—tax rates after retiring, then an annual Roth contribution makes sense. Higher future taxes can be avoided because qualified withdrawals from a Roth are free from federal income taxes (and, in some cases, state income taxes). And there’s no age limit to when you can contribute.
- Withdrawals. Roth IRAs allow you to withdraw contributions at any time without penalties. This applies only to your account contributions, not to additional money earned in the account; earnings withdrawn from your investments before age 59 ½ are penalized. If you avoid making withdrawals and make annual contributions to a Roth IRA, you’ll potentially accumulate more cash and have greater tax savings later.
Distributions from a Roth are tax-free and there’s no age limit to when you can contribute in retirement, those distributions are not counted towards your MAGI. There are no required minimum distributions, so your money can stay invested as long as you want, tax-free, making a Roth IRA a good asset to leave to your heirs if you don’t need the money in retirement.
With a traditional IRA, you may not be eligible for a deduction depending upon your income and you must start taking distributions at age 70 ½.
- Inherited Roth IRAs. If you’re a non-spouse beneficiary of a Roth IRA, you must take distributions no later than the year following the death of the original Roth IRA owner. Your assets still grow tax-free, withdrawals are tax-free, and you can change the beneficiary on the account.
If you’re a spouse beneficiary of a Roth IRA, you have two options: elect to be the beneficiary of the account, then defer distributions until the year the original owner would have turned 70 ½; or, if you choose to be the owner, you won’t have to take a required minimum distribution over your lifetime. If you take distributions, you’re still able to enjoy tax-free income.
Why you should open a Roth IRA under the new tax laws
Under the TCJA, federal income tax rates might be the lowest they’ll be for years. The IRS has posted the tax rates for 2019 here; in 2020, the rates will increase slightly due to inflation. If you open a Roth—or convert a traditional IRA to a Roth IRA—you can pay low tax rates today and avoid potentially higher tax rates in the future.
Have more questions? We can talk you through your options. Contact one of our financial planners.
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Lion Street Financial, LLC does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.