Shedding Light on Roth Accounts

by | Apr 1, 2019 | Our 2 Cents

 A Brief History of Roth Accounts: In 1997, Senator William Roth spearheaded the creation of Roth investment accounts because, as he said, “it is in the national interest both for the economy and the family that we have significant savings.” The concept behind the Roth creation was simple: Americans do not save enough money compared to citizens in other developed countries, and he wanted to incentivize younger people to start saving earlier by giving them a tax break on the growth of these accounts. However, Roth accounts are not merely for young investors, and can be a valuable component of a retirement plan. While there is a fair amount of complexity associated with Roth accounts, this article is going to focus on some key points that everyone should know. 

Quick Facts on Roth Accounts: 

  • A Roth account allows you to pay taxes upfront on the money that you contribute while any money that you take out in retirement is tax and penalty free (assuming the rules below are satisfied).
  • The idea is that a long-term retirement account will hopefully have a lot of investment growth. Assuming the rules are followed, this investment growth has the potential to be tax-free, retirement income.
  • This is very different than traditional, pre-tax retirement accounts. Those accounts give the tax break up front when contributions are made, however,taxes are owed when the money is taken out. This means that all of the investment growth is taxable.
  • Roth accounts come in 2 main types – employer-sponsored retirement accounts like Roth 401(k)s and personal retirement accounts like the Roth IRA. And yes,you may be able to contribute to both at the same time.
  • For 2019, you can contribute $6,000 during the year to a Roth IRA, or $7,000 if you’re over age 50.
  • The tax code prevents you from contributing directly to a Roth IRA if you make too much money. For 2019, a single taxpayer can’t contribute directly to a Roth IRA if she or he makes over $137,000. For married filing joint taxpayers, this phase-out is hit once they make $203,000 in income.
  • While there is a way to “backdoor” contributions into a Roth IRA for higher income earners, there are some complicated rules that could cause unintended tax consequences if they are not followed.
  • A Roth 401(k) plan has higher contribution limits than IRAs and will allow you to contribute $19,000 if you’re under 50 years of age. Once you’re over 50, you’re entitled to make an additional $6,000 catch up contribution.
  • Roth IRAs provide a high amount of flexibility before retirement. You can withdraw your own contributions any time you want without tax or penalty.While this is true, PFA would encourage you to leave your Roth money invested for retirement.
  • The 5 Year Rule on Roth IRAs states that you must wait 5 years after your initial contribution in order to be able to pull your investment growth out tax-free.
  • For tax purposes, the IRS considers Roth withdrawals to be your contributions first then growth giving you extra time to meet that 5 Year Rule.
  • If you’re near retirement and need your retirement money soon, then a Roth IRA may not make sense. You may not be able to wait 5 years in order to get your investment growth tax-free.
  • There’s another catch to consider on the investment growth. If you’re not at least age 59.5, then any investment growth taken out of a Roth IRA may be subject to a 10% early withdrawal penalty. Remember, this does not apply to your original contributions.
  • If you need immediate tax relief, a Roth account may not make sense since you don’t receive a tax break for contributing up front like you get for a pre-tax account.
  • Roth accounts are not subject to Required Minimum Distributions during your lifetime. This allows you to keep your money invested and is a major advantage.The IRS requires traditional IRA owners to take out minimum distributions each year even if they don’t need the money.

“Distributions from traditional employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.”