What you need to know about Roth IRAs.
“The avoidance of taxes is the only intellectual pursuit that still carries any reward.”
– john maynard keynes
By Shawn Perkins | Financial Planning
4 minute read
1998. What a year. The Denver Broncos beat the Green Bay Packers in Super Bowl XXXII. Microsoft released Windows 98. The Bellagio Hotel opened in Las Vegas. Saving Private Ryan premiered in theaters. Michael Jordan played his last game as a Chicago Bull beating the Jazz to win their 6th NBA title. And let’s not forget, this is all happening during a booming time in the stock market that would eventually be called, the dot-com bubble.
But one other notable thing happened 1998. At least in the eyes of financial planning nerds like me. The Roth IRA was born thanks to the passage of the Taxpayer Relief Act of 1997 and expanded the availability of retirement saving vehicles to more Americans. Those eligible were able to stash away $2,000 per year to grow tax-free for their retirement. Fast forward to today, approximately 32 million Americans own a Roth IRA (ICI)and are now able to contribute $6,500, or $7,500 if over the age of 50, for the 2023 tax year. It’s wonderful to see. However, despite its 26-year existence, I still get plenty of questions on how Roth IRAs work and if they make sense as part of a savings strategy. So, let’s talk about what a Roth IRA is, how to get money into one, and its role in your strategy.
Let’s first take a step back. There are two main types of IRAs, or Individual Retirement Accounts. Traditional IRAs and Roth IRAs. With a Traditional IRA, the money that you put in is tax deductible, meaning you can take that amount right off your taxable income that year, if you’re eligible. That money then grows tax-deferred (because remember, you haven’t paid tax on it yet) for you when you retire. At that point, when you withdraw your money after 59 and a half, you will be taxed at hopefully a lower tax rate. Meaning you get to keep more and give less to Uncle Sam. A Roth IRA is very similar in structure, but unlike a Traditional IRA, the money that you put into a Roth has already been taxed. In other words, you’re not receiving a tax benefit today for contributing to Roth. Instead, the money that grows within your Roth IRA is tax-free for the rest of your life after you reach 59 and a half. Think of it like this. In the Traditional IRA, Uncle Sam is a silent partner in that account because a percentage of that money is going to go to taxes at some point. Whereas with a Roth IRA, 100% of that money is yours. Sounds pretty good? Depends on your tax rate, and a few other factors that we need to consider, but that’s why you have me, right?
Now, there are two ways to get money into a Roth IRA. Contributions and conversions. Contributions to a Roth come from your paycheck or from your checking and savings account. You have to have earned income, which is income you receive from your job. Your contributions are limited in 2023 to $6,500 per year, or $7,500 per year if you’re over the age of 50. Additionally, you must make below $138,000 if you’re single, or below $218,000 if you’re married filing jointly to take full advantage of the contribution limits. Conversions, on the other hand, have no limits. Let’s say you’re retired and rolled over your retirement plan into a Traditional IRA. You can convert, or move, some or all of these funds from your Traditional IRA to your Roth IRA. Keep in mind, the amount you move to your Roth is taxable in that year, so a conversion strategy generally makes sense over several years to avoid paying higher taxes. Either way, you have complete control over how much or how little you want to convert from your IRA and it doesn’t matter how much income you make in any given year to be eligible for a conversion. Plus, there are no penalties for Roth conversions if you’re under 59 and a half. Generally, you can’t touch the earning in your Roth IRA until you’re 59 and a half or else you’ll incur a 10% penalty plus taxes. With a conversion, you’ll only need to worry about the taxes.
There’s also a third way to get money into a Roth IRA that is a combination of contribution and conversion, but we’ll save the fun for a future blog post.
A Roth IRA is one of the most powerful savings vehicles that you can utilize. If you’re younger and in your working years, you can capture the wonder of compounding interest to grow your contributions tax-free. You will also have access to your contributions at any time without penalty. Only the earnings are penalized and taxed if withdrawn before 59 and a half. So, in a way, your Roth IRA acts like an emergency fund as well as a retirement account. If you’re in retirement, you can utilize a Roth IRA to lower your tax bill by withdrawing funds tax-free instead of from your Traditional IRA or 401k, which are taxable. And by doing conversions, you’re also lowering your future tax liability brought on by Required Minimum Distributions. Did you think that Uncle Sam would let your IRA just grow tax-deferred forever? Sorry. Not the case.
For most people, I think having and utilizing a Roth IRA makes sense. Just be sure you’re using it correctly and avoiding any issues that may come about from withdrawals and conversions.
And please, remember to invest the contributions in your Roth IRA. I saw a post on Instagram where a woman had been diligently putting money away into her Roth IRA for years only to find out that she needed to INVEST that money for it to really grow. It had been sitting in cash the whole time. Ouch!