Roth IRA Facts

Roth IRA distributions are tax free (as long as you've met the requirements.)  Earnings on your Roth are tax free.  If you die, your heirs inherit the money tax free.  I just love things that are tax free!

Roth IRA distributions are tax free (as long as you’ve met the requirements.) Earnings on your Roth are tax free. If you die, your heirs inherit the money tax free. I just love things that are tax free!

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I write about ROTH IRAs quite a bit, but someone recently asked me to explain ROTH IRAs so here we go:

 

A ROTH IRA is best defined by how it’s different from a regular (Traditional) IRA.  Here are the differences:

 

  1. You cannot deduct contributions to a ROTH IRA, so whatever money you invest into a Roth—you’re going to pay income tax on the year you invest it.
  2. If you satisfy the requirements, your ROTH distributions are tax-free.
  3. You can still make contributions to a Roth IRA even after you reach age 70 and ½.
  4. You can leave your money in your Roth IRA as long as you live.  (This is important for people who want to leave behind money for their heirs.  It also means you don’t have any required minimum distributions (RMDs) like you have with Traditional IRAs.  )
  5. You must designate the IRA as a Roth when you set it up (the default IRA setting is for a Traditional IRA.)

 

So why am I so gung ho about Roth IRAs?  I like things that are tax free.  The distributions are tax-free, the earnings are tax-free, and if you die, they go to your heirs tax-free.  That’s a lot of tax-free going on there.

 

Here’s another thing I really like about the Roth IRA—not only are the distributions tax-free, but the distributions don’t count towards your Adjusted Gross Income.  I realize I’m going into Tax Geek Speak here, but hear me out, because this is important.

 

Let’s say you’ve got a kid in college.  You haven’t saved enough money for tuition and you need $10,000 for the tuition payment.  Now you can take that money out of your Traditional IRA and not pay a penalty (because you won’t pay the penalty for early withdrawals when you use it for tuition), but you’ll still have to pay the regular income tax on it.  So if you’re in the 25% tax bracket, you’ll pay an additional $2500 in taxes to take that $10,000 out of your Traditional IRA.

 

Now, if you need the whole $10,000 then you’ll need to actually take $13,333 out and withhold $3,333 in order to have the $10,000 and still pay your taxes on it.  Plus, the IRA money that you take out goes on your tax return as income.  So if you’re applying for financial aid, your aid will be reduced because you’re showing $13,333 more in income than if you didn’t take any money out of your IRA.  (And you could use the financial aid—you couldn’t afford the tuition, right?)

 

Now, if you had a Roth IRA, you’d take out that $10,000 tax-free.  The $10,000 wouldn’t have an impact on your tax return and therefore, wouldn’t have the same negative impact on your FAFSA application.  See why I like the Roth IRA?

 

Here’s another example of where it’s useful.  Let’s say you’re retired and receiving Social Security income.  If your money is all in a traditional IRA or pension, your extra income can make your social security taxable—up to 85% of your Social Security income can be taxed.  But if you take money out of your Roth IRA, that will have no effect on whether your Social Security gets taxed or not.  The more you have in your Roth IRA, the more opportunity you’ve got to maneuver.

 

If you’re looking for a place to put some retirement money, my first choice is a Roth IRA.  Start saving today, you’ll be glad you did.

 

For more information about Roth IRAs, here’s a link to the IRS website:  http://www.irs.gov/Retirement-Plans/Traditional-and-Roth-IRAs

ROTH IRA Strategy for High Income Earners

High income earners are often excluded from the tax-free retirement benefits of a Roth IRA, but you may be able to work around it.

High income earners are often excluded from the tax-free retirement benefits of a Roth IRA, but you may be able to work around it.

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Perhaps you’ve heard about how great a ROTH IRA is: You put your money in an account and it grows tax free and when you take the money out at retirement time you get it all tax free. Awesome, right? Zero percent is a good tax rate. But if you’re in a high income bracket (see the chart below), you’re not eligible to contribute to a ROTH. But there may be a way around that for you. It’s called a ROTH IRA conversion. Here’s how it works:

 

Even though your income may prevent you from making a ROTH IRA contribution, there is no income limit for a Traditional IRA contribution. This is important—there is no income limit to making a Traditional IRA contribution. There are income limits as to whether it is deductible or not—but no limits as to your ability to make an IRA contribution.

 

For example: let’s say you earn $200,000 a year and you have a 401(k) plan at work. You can’t make a ROTH IRA contribution and you can’t have a deductible Traditional IRA contribution either. What you can do is make “non-deductible” contribution to a traditional IRA.

 

A non-deductible contribution to an IRA pretty much does the same thing as a ROTH—it grows tax free and at retirement it you can take it out tax free. The problem with the non-deductible IRA is that when you take it out, you take it out proportionately with your taxable IRA money.

 

For example: let’s say you have $20,000 on non-deductible IRA invested and another $80,000 in a traditional IRA that you rolled over from your 401(k) account for a total of $100,000 in IRA funds. You want to take the $20,000 of non-taxable money out. You can’t do it. If you take $20,000 out, the IRS is going to tax $16,000 of it because the non-taxable money comes out proportionately to the taxable money.

 

(Geek time: 20K + 80K = 100K

20K divided by 100K = .2 or 20 percent

$20,000 times 20% = $4,000 that is tax free

$20,000 – $4,000 = $16,000 taxable IRA)

 

So this is where the ROTH IRA conversion comes in. If you don’t have any money in a traditional IRA yet, then you can take that non-deductible IRA and convert it to a ROTH IRA with no tax consequences. There are currently no income limitations on doing a ROTH IRA conversion.

 

If you convert your money into a ROTH IRA, then when you want to take that money out—you’re taking it out of the ROTH. There is no equation determining how much is taxable or non-taxable—it’s all in the ROTH and it’s all non-taxable.

 

Now if you’ve already got money in a Traditional IRA, this strategy might not work for you because you’d be taxed on those funds during the conversion. If the total amount is fairly low, you might want to consider rolling it all over and taking the tax bite. You’d want to discuss that with your financial advisor and tax person before attempting that.

 

But if you don’t have any Traditional IRA funds, the non-deductible Traditional IRA contribution and ROTH IRA conversion might be a good strategy for setting aside some tax free retirement income for you.

 

Incomes where the ROTH IRA is completely phased out (2013):

 

Married filing jointly: $188,000
Single or head of household: $127,000
Married filing separately: $ 10,000