Does the sound of a tax free income appeal to you? Then you need to definitely consider a ROTH IRA. A ROTH IRA will grow not only tax deferred but actually with tax free growth. And unlike a Traditional IRA you are not required to make any withdrawals at age 70 ½. If you have a Traditional IRA you can always do a conversion to a ROTH IRA regardless of age or earned income limitations. If you are in a lower tax bracket now it may be a good time to convert some of your Traditional IRA into a ROTH IRA and do some good estate and tax planning. Remember a distribution from a Traditional IRA is taxed as ordinary income and so would your ROTH conversion. But if you plan on leaving the funds in your ROTH IRA for over 5 years and have some room in your tax situation before you are bumped into the next highest tax bracket this is definitely something you may want to consider. And if you are still working many employers now offer ROTH 401(k) plans but they do have some differences from a ROTH IRA.
In order to open a new ROTH IRA you must have earned income in the year you open the account but you may contribute at any age as the money you place in a ROTH IRA is taxed where a Traditional IRA is tax deferred and you may not make contributions after age 70 ½. If you are under the age of 50 you may contribute $5,500 to an IRA for 2013 and 2014 and if you are over the age of 50 you may contribute $6,500 with phase outs based on your income. The phase outs for 2013 are $127,000 for single filers and $188,000 for joint returns and in 2014 they are $129,000 and $191,000 respectively. For ROTH 401(k) plans for individuals under 50 they may contribute up to $17,500 and for those over 50 they may contribute $23,000 for both 2013 and 2014. ROTH 401(k) contributions must be made by December 31st and IRA contributions may be made until April 15th for the previous tax year.
If you do not have earned income you may still open and have a ROTH IRA you will just have to do it through a conversion of a Traditional IRA. And unlike normal contributions you are not limited in a conversion IRA with exception to tax consequences. One way to minimize the tax bill is to convert a Traditional IRA over several years ensuring you do not bump yourself into a higher tax bracket. But make sure you have the money already outside of an IRA when you do the conversion or you will be adding extra taxes onto those encountered by the conversion IRA with more in taxes from the Traditional IRA to cover all the expenses. When you consider a conversion IRA it is best to meet with a tax advisor or financial planner to make sure you do not bump yourself into a higher tax bracket, convert so much you hit the surcharge tax of 3.8% or affect your Medicare Part B and D is you are over age 65.
Now you also need to plan on if and when you will do a conversion from a Traditional IRA to a ROTH IRA. If you are in a higher tax bracket now and you project you will be in a lower one once you do retire it is better to do the conversion after you retire. However, if you are already in a lower tax bracket convert as much as you can before you reach the lower limits of the next tax bracket.
Now here are some special features of a ROTH IRA that you may or may not need to be aware of. As the money you put in a ROTH IRA is taxed you may withdrawal that money after 5 years from the conversion date if you are under age 59 ½. If you have had the converted IRA for at least 5 years and are older than 59 ½ there are no restriction on your withdrawals. Now the five years begins on January 1st of the year in which you did the conversion and will extend 5 years until the January of the 5th year. If you convert an IRA in 2013 the date of the conversion would be considered January 2, 2013 and therefor the 5 years would be up January 1, 2018. The 5 year conversion rule applies to each conversion and not the IRA as a whole.
As far as using a ROTH IRA as an estate planning tool they are excellent choices for that purpose. ROTH IRA’s may be left to anyone regardless of their age and depending on who it is left to will determine the rules that will apply to it. If you leave a ROTH IRA to a child, grandchild or anyone other than a spouse they will have to start taking minimum distributions the year following your death. That allows young people to enjoy a lifetime of tax free growth in a ROTH IRA. If the ROTH IRA is left to a spouse there is no requirement to take the minimum distribution. While leaving a ROTH IRA may defer the taxes on the IRA itself it will still be included in your taxable estate. In the event you will leave an IRA to a charity do not under any circumstance convert a Traditional IRA to a ROTH IRA as charities do not pay taxes on the gift under either circumstance. If you convert a Traditional IRA to a ROTH you are just paying unnecessary taxes.
If you convert a Traditional IRA to a ROTH IRA and for some reason you made an error in doing so you have until October 15th of the following year to characterize the IRA back. If you do not have the money to pay the conversion taxes you may change the IRA back or if the value of the IRA has a dramatic decrease you may want to switch it back as well. You can also convert a Traditional 401(k) into a ROTH 401(k) but that is a permanent change that cannot be undone. Also ROTH 401(k) accounts are subject to minimum withdrawals starting at age 70 ½ unless you are still working for the company that holds the 401(k).
