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Does the name Sen. William Victor Roth Jr. mean anything to you? If you’re saving for retirement, then you should know and thank Roth. He was the sponsor of the 1997 legislation that created his namesake — the Roth IRA.
The Roth IRA is a retirement savings plan used by millions of people to build wealth over time. It’s a great way to save because it offers tax-free growth. That means the capital gains aren’t taxed every year in a Roth. And when you take money from a Roth in retirement, unlike a “traditional IRA,” that money isn’t taxed, so you have more of every precious dollar.
Some basic points:
• Investors use after-tax dollars (unlike a 401(k) that uses pretax money) to fund a Roth IRA account
• Roth gains are not taxed when withdrawn as long as the account has been established for 5 years and you are over 59½
• A traditional IRA is tax-deductible (for some income levels) when it’s funded, but later withdrawals are taxable
What’s the difference between a 401(k) and a Roth 401(k)?
What’s a conversion?
You may have heard of people “converting” to a Roth. Many people will convert retirement accounts such as a 401(k) or a traditional IRA into a Roth. For example, you leave your job and have $100,000 in a 401(k), you can convert it to a Roth IRA. You then owe taxes on the conversion because your 401(k) was built from “before tax” cash.
Conversions from traditional IRAs are treated differently, depending on the types of contributions you initially made to the traditional IRA.
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More flexible savings
Compared with traditional IRAs, Roth IRAs offer more flexibility. You can take out any contributions (the money you put in) at any time without penalty. Paying college bills or have an emergency? Use the Roth IRA contributions.
With the traditional IRA, there’s also “required minimum distributions” at age 70½. You must take out a minimum amount starting at that age. But what if your other investments, Social Security, or pension cover your expenses? This is another way the Roth is more flexible, as there are no required withdrawals at any age. You can let the money sit there and grow tax-free and contribute to the Roth at any age.
Income limits for high earners
With the Roth IRA, you can’t contribute as you hit certain income levels. High earners at certain Modified Adjusted Gross Income (MAGI) thresholds can either contribute a reduced amount or zero to a Roth IRA. Talk to your tax pro about calculating MAGI. Limits where contributions are not permitted:
• Single filers for 2020 must keep their (MAGI) under $139,000 for the year
• Married couples filing jointly must keep their MAGI under $206,000 for 2020
There is also a sliding scale for incomes below the limits up until $124,000 for single filers and $196,000 for joint filers.
Are you disheartened that you make too much money and can’t enjoy a Roth? Never fear, for there is a way.
Read: Why your Social Security check could feel a lot smaller next year
Leveraging a ‘backdoor’ Roth IRA
Investors that make too much money for regular Roth IRA contributions can instead get in what’s known as a “backdoor Roth IRA.” It’s still a Roth IRA, the industry just calls it a “backdoor” because of how it’s structured. Here’s how it works:
• Open and contribute to a traditional IRA
• Perform a Roth IRA conversion immediately, turning the traditional IRA into a Roth
• Talk to your tax professional about possible taxes. If the funds for this Roth were nondeductible, then you won’t be double taxed. Your tax person will need to use IRS Tax Form 8606 “Nondeductible IRAs” to manage your tax implications.
How is this possible? It’s the result of changes in the tax code in 2010. The changes removed a limit to the amount people could convert into a Roth. Previously, if you made more than $100,000 a year then you couldn’t convert. But after this change, it opened the floodgates for higher earners that were eager to leverage the flexibility and tax advantages of the Roth IRA. Now, anyone can contribute to a Roth IRA through the backdoor process and enjoy the advantages.
No matter how you get your money into one, the Roth IRA is a powerful tool for retirement. The combination of tax-free growth, withdrawals, and flexibility makes it a great choice for anyone looking to fully enjoy their golden years.
Blake Skadron is chief operating officer at iTrustCapital.
