Are you saving for your retirement? Do you own and contribute to a ROTH IRA? If you are not, I hope you will consider a ROTH and if you have one you need to be aware of some ROTH centered facts. Yes, there is a difference between a ROTH IRA and a Traditional IRA that you need to be aware of and more importantly understand. First, we will look at one of the more apparent differences, and that is a Traditional IRA is normally tax deductible in the year the contributions are made and with a ROTH you pay taxes on them in the year they were earned, and the contributions were made. Then on the other side when you withdraw the funds after you reach age 59 ½ the ROTH is totally tax-free where the Traditional IRA is taxed in its entirety at ordinary income tax rates at the time of the withdrawal.
Now, there are income limitations on both types of IRA’s, and they can change from year to year. For a Traditional IRA, the tax deduction is phased out at certain income limits. As for a ROTH, which is what this post is about, the contributions are limited to individuals who earn less than $133,000 and married filing joint at $196,000 for 2017. The contribution levels are equal for both IRA and are also set annually with the limit this year is $5,500 for those under age 50 and for those over age 50 you are allowed an extra $1,000 in annual contributions.
So are you out of luck if you earn more than the limits established by the IRS in a given year for the ROTH option? The answer to that is not necessarily. There is a way high wage earners can contribute to either IRA and then have it become a ROTH if that is what you so choose. If you are indeed a high wage earner, you can make taxable contributions to a Traditional IRA as you will most likely not be eligible for the tax deductions anyway. Then once you have made the taxable contributions to the Traditional IRA, you can elect to convert that to a ROTH IRA. And if you do it fast enough you should not owe any additional taxes on the contributions. But if you do delay the conversion and the contributions have made any gains you will have a tax liability on those gains when the conversion is made. Please note, here I am talking about non-deductible Traditional IRA contributions. For a Traditional deductible IRA, there could be a significant tax liability when and if you make such a conversion as the entire amount will be treated as income and could have severe tax consequences for you in the year of such a conversion.
Now when it comes time to make withdrawals from your IRA, there are some issues as well that you need to be made aware of. First, in a Traditional IRA, you must start making required minimum withdrawals at age 70 ½ no matter what. The reason for this is the government wants its taxes that are owed on these funds as they have been in a tax-deferred account hopefully for many decades. For a ROTH IRA, there is no age limitation on when you must withdraw the funds, and this can be passed on to the beneficiary as well but they will at that point be required to make minimum required withdrawals at the time they inherit the IRA, but it will still pass as tax-free money to your heirs. Second, unlike a Traditional IRA, you must wait a minimum of five years from your initial contribution to a ROTH before you may make a tax-free withdrawal. That means if you are age 56 when you open your ROTH IRA you cannot make a true tax free withdrawal until you reach age 61 or it will be taxed as ordinary income. The five years is calculated from the initial contribution and not from when each was made. Be aware of this requirement and avoid unnecessary taxes and penalties.
Unlike a Traditional IRA, you are allowed to withdraw the principal of a ROTH IRA at any time since the taxes have already been paid on that money. But know that in doing so you open yourself up to more long-term damage. Yes, the funds you take out are not taxed or penalized as they would be in a Traditional IRA, but you are missing out on a lot of earnings potential depending on where you are at age-wise when you make the withdrawal of principal. A $15,000 withdrawal when you are 30 years old means that money could go almost another 30 years earning you is a tax-free return that you will not have if you withdrawal the funds. At a modest 7% annualized, that could mean you lose out on over $114,000 on that $15,000 withdrawal in a ROTH account. That is something that needs to seriously be considered when you contemplate any withdrawal of principal.
ROTH IRA’s is most likely the best savings tool we have for our retirement, so it is well worth knowing how they function. And now many employers are offering ROTH 401(k)’s as well so if your company does indeed offer this you may want to consider it as well. Though they are similar, there are some differences between an IRA and a 401(k) that are both ROTH so do your homework there.
If you need more information or just have some questions, feel free to leave a comment here or contact me directly.
