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Are you considering whether or not you should open a Roth IRA? For as long as I’ve known about one, a Roth IRA has been one of my favorite retirement savings tools.
The reason is simple: A Roth IRA offers you tax-free income when you retire. When I first heard about this, it just seemed like such an obvious win-win deal. I mean who wouldn’t want to enjoy tax-free money for the rest of their lives?
However, when you take a closer look at some of the rules and size it up against the other options, then there could be some instances where maybe it’s not your top pick.
In fact, there are some circumstances where you might end up paying more in taxes to have a Roth than you would with other types of retirement accounts.
In this post, I’d like to explore what a Roth IRA is, how it works, and how it can be used to benefit you. We’ll also compare it to other retirement plans and give you everything you need to know about whether or not you should open an account.
What is a Roth IRA?
A Roth IRA is a type of individual retirement account where the benefits are tax-free instead of tax-deferred. This is because you’ll pay your taxes in the year that you make your contributions rather than when you retire.
The Roth IRA was signed into law under the Taxpayer Relief Act of 1997. Originally called an “IRA Plus”, it was named after the main sponsor of the legislation Senator William Roth of Delaware.
Today, Roth IRAs are very commonplace and you can open one anywhere that retirement accounts are offered: Brokerages, banks, trading apps, robo-advisors, etc. The concept has become so popular that many 401k plans now also offer Roth-style options.
How Does a Roth IRA Work?
The mechanics behind a Roth IRA are fairly straightforward:
- Start by making your contributions for the year. At the end of the year when you file your federal tax return, those contributions will not be deducted from your AGI (adjusted gross income). Therefore, you’ll be paying taxes on them.
- Your contributions will grow tax-free. Similar to other types of retirement accounts, your contributions will go towards investments that have the potential to grow and multiply over time. During these accumulation years, you won’t owe any taxes on the earnings you make within the Roth IRA.
- Enjoy tax-free distributions. After age 59-1/2, you can start taking making penalty-free withdrawals from your Roth IRA to use for retirement income. Any funds you withdraw will be tax-free.
I always tell people that you can basically think of a Roth IRA as the opposite of how a traditional IRA (or even a traditional 401k) works.
With a traditional-style account, you skip the taxes on your contributions now and instead defer paying them into the future when you’ll pull money out to use as retirement income. It’s just a question of when you’d prefer to pay your taxes: now or later.
How Does a Roth IRA Help Me to Retire?
Like all retirement accounts, the ultimate goal is to invest your money for the long term and take advantage of compound growth. Compound growth is money that grows on top of the money you contributed plus any other earnings you’ve made along the way.
It’s how your savings can eventually multiply two, three, … ten times over!
But also with IRS sanctioned plans, the other benefit is the tax break. And in the case of a Roth IRA, that tax break is at a time when I feel you’ll need it the most: When you’re retired and on a relatively fixed income.
Remember that with a traditional IRA and 401k, you’ll receive your tax break upfront. But then when they eventually come due, those taxes will eat into your retirement budget.
For me, being elderly and on a fixed income is not the time to be paying taxes. You might get to a point where you’re physically or mentally unable to go find work if you need extra income. By contrast, your income is much more flexible during your younger, working years.
This is why I believe a Roth can put you in a better overall position. The less you owe to the IRS, the more you’ll truly feel like you’ve achieved financial freedom.
Other Important Things to Know About a Roth IRA
Before you open a Roth IRA, there are a few other important details you should know.
Every taxpayer with earned income is allowed to contribute up to $6,000 per year into a Roth IRA. This limit increases to $7,000 per year if you’re age 50 and older thanks to what’s called a “catch-up contribution”.
You don’t have to make your contributions all at once. You can make them throughout the year as you please. I have mine auto drafted from my bank account in equal amounts of $500 per month.
If you’re married, then both you and your spouse can each have your own Roth IRAs and effectively save twice as much. My wife and I each have our own unique Roth IRA accounts – one in my name and one in hers. This lets us save $12,000 per year total instead of just $6,000.
The $6,000 IRS limit applies to the sum of all your IRA contributions for the year, not just your Roth. So, if you had the opportunity to contribute to both a traditional IRA and a Roth IRA, you can’t save $6,000 to a Roth and $6,000 to a traditional for a total of $12,000. You could instead save $3,000 and $3,000 (or any combination that adds up to $6,000 or less).
Contributions have to be made before the end of the tax year. Keep in mind that’s different from the calendar year. Since most tax years end in April of the following year, this means you’ll have approximately 16 months to contribute to your Roth IRA.
Minors and Contributions
If you have teenage children who work a part-time job, they are also able to contribute to a Roth IRA. However, the contribution amount may be limited if their gross earnings were less than the $6,000 limit. For instance, if they only earned $2,000 before taxes, then the most they can contribute to a Roth IRA for the year is $2,000.
After both of my kids got jobs as teenagers, I helped them to open Roth IRAs. This was not only to teach them about saving and investing but also because the compound growth on the money they set aside starting at age 15 would be amazing by the time they’re my age!
Obviously, most teenagers could care less about saving for retirement and would rather spend that money on other things that kids buy. So, as an extra motivator, I offered to match whatever they saved.
For example, if they saved $1,000, I also contributed $1,000. That way they could do both things: Start a Roth IRA as early as possible but still have some money to enjoy.
And yes, under the IRS rules, it is okay to help your children fund their IRA as long as the total contribution does not exceed their gross earnings.
One common problem with Roth IRAs is that you may not be able to contribute to one if you earn too much money. The IRS has specific rules on who can contribute based on their taxable income and tax filing status (single, married filing jointly, etc.). You can find them all here.
For instance, a single person with an AGI over $125,000 will no longer be able to contribute the full $6,000 into their Roth IRA. Between $125,000 and $140,000, the eligible amount will gradually decrease (maybe to $4,000 or $2,000). If their income ever exceeds $140,000, then they can no longer contribute to a Roth IRA.
If you earn too much money to meet these income requirements, then there’s still hope. There is a well-known technique called a Backdoor Roth IRA Conversion where you’re allowed to convert a portion of your traditional retirement savings over to a Roth.
The good news is that there are no income restrictions or limits to a Roth conversion. However, you have to keep in mind that any amount you convert will count towards your taxable income for the year.
So, for instance, let’s say you had $300,000 in a Rollover IRA from a previous employer. It wouldn’t make sense to convert this to a Roth all at once because it might push your taxable income into the 37 percent marginal tax bracket!
A smarter approach would be to convert a little at a time over several years so that your marginal tax rate stays low and your tax bill is kept to a minimum.
Just like most other retirement plans, you’re not supposed to start making withdrawals until after age 59-1/2 (presumably as retirement income). However, there is one major exception to Roth IRAs that makes them unique: Contributions can be withdrawn at any time.
When it comes to your retirement accounts, it helps to compartmentalize them into two groups: Contributions and earnings.
- Contributions. This is the money you personally saved into your Roth IRA. Since you’ve already paid taxes on this money, the IRS says you’re free to withdraw them as needed.
- Earnings. The earnings are the money that grew on top of your contributions and previous earnings. Since this is effectively “new money” that has not yet been taxed, it cannot be withdrawn early.
The cost of withdrawing your earnings before age 59-1/2 is the same as other retirement accounts: You’ll have to pay taxes plus a 10 percent penalty fee.
If you wait until after age 59-1/2 to take out your earnings, then they will be available tax-free. However, your Roth IRA does have to meet something called the 5-year rule.
This is basically a requirement that says your Roth IRA has to have been open for at least 5 years since your first contribution for the earnings to qualify as tax-free.
This ability to withdraw Roth contributions anytime you want is an extremely useful resource to have. You could think of it as almost like a backup emergency fund. When our home became damaged after a storm, we considered tapping our Roth IRA contributions as a way to pay for repairs until the insurance payments came through.
Thankfully, we didn’t end up having to. However, it was nice to know that we had a tax-free, penalty-free option on the table if it came to that.
Like we already mentioned, you can basically open a Roth IRA anywhere that offers retirement accounts. This means that you have a wide variety of assets you can invest your money into:
- Mutual funds
- ETFs (exchange-traded funds)
- Savings accounts
- Precious metals,
Personally, I’m old school and stick with mutual funds. I have an asset allocation I like to maintain and use a variety of index funds to achieve them. It’s boring, but it does produce steady and reasonable returns.
Roth IRAs and Early Retirement
By now it’s clear that saving your money to a Roth IRA is a great way to lower your tax bill when you’re older. But what about if you plan to retire early (like me)?
Many F.I.R.E. enthusiasts love Roth IRAs because they can be used to bridge your income during those gap years between the time you retire and when you finally turn age 59-1/2. Here are two ways they do this.
Penalty-Free Withdrawals on Contributions
As we already mentioned, Roth IRA contributions can be pulled out any time before age 59-1/2 without penalty because you’ve already paid taxes on this money. Depending on how long and how much you and your spouse have been contributing to your plans, this could mean you’ve got a huge source of penalty-free income available.
For instance, let’s say both you both contribute to your Roth IRAs for the next 25 years. If we make things simple and don’t adjust for inflation, that means you could have:
2 IRAs x $6,000 each x 25 years = $300,000 available to withdraw
If you decide to retire and use those contributions as an income source over the next 10 to 15 years until you turn age 59-1/2, that’s $20,000 to $30,000 per year. It’s not enough money to retire on alone, but it’s certainly a huge help.
Advanced Strategy: Roth IRA Conversion Ladders
The second and more complex way that Roth IRAs can be used to fund an early retirement is to implement what’s called a Roth Conversion Ladder.
Remember the backdoor Roth IRA we talked about earlier? A Roth Conversion Ladder is an advanced strategy that combines those conversions with another little-known loophole: After 5 years, those conversions are treated as contributions, meaning that they can be withdrawn penalty-free.
Putting this all together, the process behind a Roth Conversion Ladder works like this:
- Take the money from your traditional 401k and roll it over into a traditional IRA. You’ll want to do this because your 401k plan might have rules that could block you from making conversions to a Roth IRA. (Believe it or not, that tip was actually recommended to me years ago by a customer representative from Vanguard during a phone call.)
- Next, make a modest conversion from your traditional IRA to a Roth IRA. Remember that you’ll have to pay taxes on this conversion, so don’t go too crazy with how much you convert. Let’s call this Year 1 and say you converted $20,000.
- Repeat this step for Years 2 through 5 converting another $20,000 each time. This will effectively add new rungs to the ladder each year.
- On Year 6, that conversion from Year 1 is now available for you to withdraw penalty-free. You can also make another new conversion (so that it will be available in Year 11).
- In Year 7, your conversion from Year 2 is now available penalty-free. Continue this cycle for as long as needed.
If that was slightly confusing, you’re not alone. The first time I read about this strategy, I had to draw it out on paper before I truly could understand how all the pieces were working together.
Fortunately, a lot of great personal finance enthusiasts have created blog posts and videos that do a better job explaining it than I can. For a very detailed example of how a Roth IRA Conversion Ladder works, check out this guide here.
How a Roth IRA Compares to Other Retirement Plans
When it comes to saving for retirement, you’ve got a lot of options to choose from: 401ks, IRAs, self-employed plans (if you have a side hustle), taxable investments, etc.
So how does a Roth IRA stack up against all these other possible tools?
In this section, we’ll highlight some of the potential advantages and what that can mean for your overall retirement planning strategy.
1. Tax-Free Income
Even though we’ve said this already, it’s worth repeating one more time: The big advantage to Roth IRAs over traditional-style accounts is that you’ll create tax-free income.
Taking those tax breaks when you’re younger and able to earn more doesn’t really seem as logical. You could always supplement your losses or even work longer if you wanted to shore up the difference while you’re young.
But when you’re older and retired, every dollar will count. And the less that you’ll owe the government, the better!
2. Higher Income Limits
Most middle-class workers will find they actually earn too much to make a tax-deductible contribution to a traditional IRA, even if that was their preferred choice. Therefore, the Roth IRA might be their only option to save money in a tax-advantaged way.
To put this into perspective, consider the following income limits for a married couple that files jointly:
- $105,000 for a traditional IRA
- $198,000 for a Roth IRA
To clarify, you’re always allowed to contribute to a traditional IRA. But in order for those contributions to be considered tax-deductible, they have to meet these IRS income requirements. Otherwise, you’ll still pay taxes on them just like you normally would on earned income.
3. Avoiding a Higher Marginal Tax Bracket
Compared to a traditional IRA or 401k, Roth IRA distributions are going to allow you to enjoy more of your money in retirement – even if you should technically be in a higher marginal tax bracket.
Though most people have fewer expenses in retirement than they had while they were working, it’s entirely possible that how you save your money and which buckets you pull from might push you from the 22 and 24 percent brackets to the 32 or 35 percent brackets.
Here are a few circumstances where this could be possible:
- You’re an incredible saver. Perhaps throughout your career, you managed to save and invest so much money that your nest egg is now huge! For instance, maybe you earned $100,000 annually during your working years but once you retire you’ve got so much money in your nest egg that you can safely enjoy $200,000 per year.
- You start a business. Many people start to get that entrepreneurial itch as they get mid-way into their careers, and this might lead you to become your own boss working as a freelancer or consultant. Depending on how things go, you might have the good fortune of making more revenue than you are right now at your job. However, that would also mean potentially escalating into a higher tax scenario.
- You’re forced to. Eventually, the government gets tired of waiting to collect the deferred taxes on your traditional IRA and 401k. Starting at age 72, they begin to impose what’s called RMDs or required minimum distributions where you have to start withdrawing a minimum amount of money from these accounts or pay a hefty 50 percent penalty. The more money you have saved into these accounts, the higher your RMDs will be, and the more taxable income that will be counted when you file your tax return.
- Government changes. None of us really know what the future holds in terms of taxes. Throughout the twentieth century, the tax rates have changed several times. You might expect to be in a lower tax bracket when you retire only to have legislation change it to a much higher rate.
In each of these situations, a Roth IRA could help. By paying your taxes now rather than later, you’ll be able to enjoy your savings without the fear of what it will do to your tax bill.
4. Access to Contributions
Compared to other retirement plans, having access to those Roth IRA contributions can be a very useful part of your safety net.
Some people will argue that you have the ability to borrow from your 401k if you truly needed money. However, the thing people forget is that your 401k plan administrator (i.e. your employer) has to approve this loan before it can take place.
I’ve worked for two employers and both of them make it pretty much next to impossible to borrow against your 401k. Plus, do you really want your employer to know your financial business anyways?
There are also “hardship withdrawals” you can take from 401ks and IRAs. But these are pretty specific and unique circumstances such as a medical emergency or first-time home purchase. If something else happens to you that doesn’t check one of their boxes, then it’s not going to qualify as a penalty-free withdrawal.
Like I mentioned already, having those Roth contributions as a backup emergency fund is a nice addition to your safety net. Though I would recommend having a designated emergency fund that you can pull from, the Roth still can be a nice Plan B or even C.
At one point, we were even considering using our Roth IRA contributions as a potential way to fund a down payment on an investment property. Although the project didn’t end up moving forward, it was good to know that the option was always there.
5. Potentially Lower Taxes on Social Security
A lot of people don’t realize this, but not all of the benefits you’ll receive from Social Security are taxable. For instance, if you’re a married couple filing jointly and your taxable income is:
- Less than $32,000, then you don’t owe any taxes
- Between $32,000 and $44,000, then you’ll owe taxes on up to 50 percent of your benefits.
- Over $44,000, then you’ll owe taxes on up to 85 percent of your benefits.
Remember that since your Roth IRA withdrawals don’t count towards your taxable income during retirement, that means this will help you to potentially pay less to the government on your Social Security benefits.
When a Roth IRA Might Not Be a Good Idea
Admittedly, I’m a pretty strong supporter of the benefits of a Roth IRA. But at the same time, I recognize that every financial situation is different, and there may be retirement plans where a Roth IRA isn’t the best fit.
Here are a few examples.
1. If You Retire to a Lower Tax Bracket
Although it would be nice to enjoy your golden years in luxury, the truth is that the majority of retirees will end up living off of less money than they earned during their working careers. This is perfectly natural because you’ll probably have large expenses like your mortgage, auto loan, and student loans paid off by then.
If you sincerely believe this will be the case for you, then contributing to a Roth IRA would put you at a disadvantage. For instance, you might be in the 32 percent tax bracket now and transition to the 22 percent tax bracket in retirement if your taxable income goes down.
In that case, it would make more sense to pay your taxes during your retirement years when the rate is lower as opposed to your higher-tax rate working years.
2. If You Believe Tax Laws Will Change Significantly
Going back to the notion that no one knows what the future will hold, there’s always a possibility that the tax laws could change unfavorably for Roth IRA accounts.
For instance, if the government wanted to find a way to stabilize Social Security or subsidize some other assistance program, they might get greedy and start coming up with bad ideas for all those Roth IRA earnings that retirees plan on collecting tax-free.
For instance, they could pass new legislation to put a small tax on that portion of your distributions, making them no longer 100 percent tax-free.
You might say to yourself: There’s no way they could do that. But history has demonstrated that when the government needs money, it can do pretty much anything they want.
For example, during World War II, the highest tax rate was raised to 94 percent to help fund the war efforts. When times get tough, things can change!
3. If You Make Charitable Contributions
If you’re the charitable type (or you would like to be later in life), then there may be some pretty lucrative tax benefits to doing so. One of the tricks that wealth managers use to reduce their clients’ tax bills for the year is to make what’s called QCDs (qualified charitable distributions) from their traditional 401ks and IRAs.
Why from traditional-style accounts? Because QCDs also count towards your RMDs. Because they are going to a charity, they are exempt from tax (up to $100,000 of your income). In other words, they’re a way for you to meet the IRS’s RMD requirements and not have to pay taxes on the distributions.
Therefore, if all of your money is in Roth-style accounts, then this strategy won’t work. Since you already paid taxes on your Roth funds and aren’t required to take RMDs, then there’d be no tax benefits to these charitable contributions.
4. You Might Never Enjoy the Tax-Free Benefits
Okay, not to be a downer, but there’s one more reason to consider why Roth IRAs might not be everyone. If something tragic were to happen to you (car crash, sickness, etc.), then you might not be around to receive all of those tax-free benefits.
Anyone who uses Roth-style accounts will have to pay their taxes now and have less money to spend than someone who uses traditional-style accounts. That means if something unfortunate happens, all of that sacrificing and paying taxes upfront could be for nothing.
The good news is that you can pass this Roth IRA onto an heir. According to the SECURES Act, they have 10 years to empty the funds. And yes, all of the distributions will be tax-exempt.
The Bottom Line
A Roth IRA is a retirement account where you pay the taxes now on your contributions and enjoy tax-free income when you retire. Essentially, it works the opposite of how a traditional IRA works.
Like all retirement accounts, the idea is that you’ll invest for future compound growth. However, Roths have the added benefit of lowering your tax bill in retirement. That’s going to be really useful when you’re older and on a fixed income.
Just like a traditional IRA, you’re limited to contribute $6,000 per year (or $7,000 if you’re age 50 and older). You also have to meet income limits to qualify to make contributions. However, there is a loophole called a Backdoor Roth IRA Conversion where you can convert traditional account funds into your Roth as long as you pay the taxes on them.
Roth IRAs can be particularly useful for those people who want to retire early. You’ll have penalty-free access to the contributions and the opportunity to use a more advanced strategy called a Roth IRA Conversion Ladder.
There are many reasons why I like saving my money to a Roth IRA. Not only will I avoid entering a higher marginal tax bracket, but this will also help me to potentially avoid taxes on my Social Security benefits. Having early access to the contributions also makes a nice backup emergency fund too.
Of course, a Roth IRA will not be for everyone. If you’ll retire to a lower tax bracket or think the IRS rules will change, then paying your taxes now might not make the most sense. You might also miss out on leveraging charitable contributions or make all those sacrifices for nothing if something tragic were to happen.
However, with all of that said, I still believe a Roth IRA has a place in most people’s retirement plans. Anytime the IRS allows you to get tax-free income, whether it’s through contributions or conversions, it’s another step closer to achieving financial freedom.