Jane Young, CFP, EA
A Roth IRA can be an excellent vehicle to save for retirement but it’s not without limitations. With a Roth IRA you invest after-tax dollars that grow tax free and can be withdrawn tax free in retirement. This can be beneficial unless you are currently in a high tax bracket and anticipate being in a lower tax bracket in retirement.
Income limitations can be a significant downfall with Roth IRAs. During your highest income years you may be ineligible to invest in a Roth IRA and there can be substantial penalties for making ineligible contributions. In 2015 the income limit for someone filing single begins at $116,000 and the income limit for someone filing married filing jointly begins at $183,000. If you make a contribution and your income exceeds the limitations, you have until your tax deadline, including extensions to withdraw your contribution. It’s easy to inadvertently make ineligible contributions and there aren’t many red flags to alert you to the problem. If you don’t withdraw excess contributions within the deadline you will incur a 6% penalty for every year the money remains in your Roth IRA.
Also be careful not to exceed the annual Roth IRA contribution limits. In 2015 the contribution limit for investors under 50 is $5,500, if you are over 50 you can make an additional catch-up contribution of $1,000. Also keep in mind that Roth IRA contributions can only be made with earned income.
If your earnings exceed the income limitations and you still want to participate in a Roth IRA, you may have several options. Your employer may offer a Roth 401k in addition to a traditional 401k. With a Roth 401k, your employee contributions can go into the Roth option but the employer match must go into a traditional 401k. A second option is to convert a traditional IRA to a Roth IRA but the amount converted is taxed as regular income in the year of conversion. As a refresher, with a traditional IRA and 401k you invest with before tax dollars and you pay regular income tax on the full amount when you withdraw the money. Finally, you can consider investing in a non-deductible IRA and immediately convert it to a Roth IRA, also known as a backdoor Roth IRA.
Initially, the backdoor Roth sounds like the perfect solution because there is no income limitation on a non-deductible IRA and it’s funded with after tax dollars. Theoretically, immediate conversion to a Roth IRA should be tax free. The hitch comes from the IRS rule requiring you to aggregate all of your IRAs and proportionately include money from all IRAs in your Roth conversion. Traditional and rollover IRAs are comprised of pre-tax dollars so the proportion of the conversion coming from these IRAs will be taxed as regular income. Although backdoor Roth IRAs can be complex but they can be a good option if you don’t own other IRAs.
Jane Young, CFP, EA
Many large employers have started offering employees the choice between a traditional 401(k) and a Roth 401(k). However, only a small percentage of employees have elected to contribute to a Roth 401(k). The primary difference between the two plans is when you pay income taxes. When you contribute to a traditional 401(k) your contribution is currently tax deductible, but you must pay regular income taxes on distributions taken in retirement. Contributions to a Roth 401(k) are not currently deductible, but you pay no income taxes on distributions in retirement. As with your traditional 401(k), your employer can match your Roth 401(k) contributions, but the match must go into a pre-tax account.
There are several differences between a Roth 401(k) and a Roth IRA. In 2014, annual contributions to a Roth IRA are limited to $5,500 plus a $1,000 catch-up contribution if you are 50 or over. Contribution limits on Roth 401(k) plans are much higher at $17,500 plus a $5,500 catch-up contribution, if you are 50 or over. Additionally, there are income limitations on your ability to contribute to a Roth IRA, and there no income restrictions on contributions to a Roth 401(k). Additionally, upon reaching 70 ½ you must take a required minimum distribution from a Roth 401(k). You are not required to take a distribution from a Roth IRA at 70 ½. However, you do have the option to transfer your Roth 401(k) to a Roth IRA prior to 70 ½ to avoid this requirement.
The decision on whether to invest in a Roth or traditional 401(k) depends primarily on when you want to pay taxes. If you are currently in a low tax bracket and believe you will be in a higher tax bracket in retirement, a Roth account may be your best option. On the other hand, if you are currently in a high tax bracket and you think you may be in a lower tax bracket in retirement, a traditional 401(k) could be your best option. A Roth 401(k) is generally most appropriate for younger investors who are just getting started in their careers or someone who is experiencing a low income year. People who are in their prime earning years may be better off taking the current tax deduction available with a traditional 401(k).
Unfortunately, it’s difficult for most of us to know if our tax bracket will increase or decrease in retirement. It is also hard to know if tax rates will increase before we reach retirement. From a historical perspective, tax rates are currently low and some believe future rates will be increased to help cover the rising federal debt. Amid this future uncertainty, your best option may be to split your contribution between a Roth and traditional 401(k). This will give you some tax relief today and some tax diversification in retirement.
Jane Young, CFP, EA
One of the biggest decisions associated with saving for retirement is choosing between a Roth IRA and a Traditional IRA. The primary difference between the two IRAs is when you pay income tax. A traditional IRA is usually funded with pre-tax dollars providing you with a current tax deduction. Your money grows tax deferred, but you have to pay regular income tax upon distribution. A Roth IRA is funded with after tax dollars, and does not provide a current tax deduction. Generally, a Roth IRA grows tax free and you don’t have to pay taxes on distributions. In 2013 you can contribute up to a total of $5,500 per year plus a $1,000 catch-up contribution if you are over 50. You can make a contribution into a combination of a Roth and a Traditional IRA as long as you don’t exceed the limit. You also have until your filing date, usually April 15th, to make a contribution for the previous year. New contributions must come from earned income.
There are some income restrictions on IRA contributions. In 2013, your eligibility to contribute to a Roth IRA begins to phase-out at a modified adjusted gross income of $112,000 if you file single and $178,000 if you file married filing jointly. With a traditional IRA, there are no limits on contributions based on income. However, if you are eligible for a retirement plan through your employer, there are restrictions on the amount you can earn and still be eligible for a tax deductible IRA. In 2013 your eligibility for a deductible IRA begins to phase out at $59,000 if you are single and at $95,000 if you file married filing jointly.
Generally, you cannot take distributions from a traditional IRA before age 59 ½ without a 10% penalty. Contributions to a Roth IRA can be withdrawn anytime, tax free. Earnings may be withdrawn tax free after you reach age 59 ½ and your money has been invested for at least five years. There are some exceptions to the early withdrawal penalties. You must start taking required minimum distributions on Traditional IRAs upon reaching 70 ½. Roth IRAs are not subject to required minimum distributions.
The decision on the type of IRA is based largely on your current tax rate, your anticipated tax rate in retirement, your investment timeframe, and your investment goals. A Roth IRA may be your best choice if you are currently in a low income tax bracket and anticipate being in a higher bracket in retirement. A Roth IRA may also be a good option if you already have a lot of money in a traditional IRA or 401k, and you are looking for some tax diversification. A Roth IRA can be a good option if you are not eligible for a deductible IRA but your income is low enough to qualify for a Roth IRA.