What is a Roth IRA and how does it differ from a traditional IRA?
Like traditional RIAs, Roth IRAs provide investors with a tax-deferred way to save money for retirement. Both accounts allow invested funds to grow tax-free. The primary difference between the two types of accounts relates to how contributions and distributions are taxed.
You make pre-tax contributions to a traditional IRA. You make after-tax contributions to a Roth IRA. While you pay taxes on withdrawals from a traditional IRA, if you’re at least 59 ½ years old, you generally don’t pay taxes when you withdraw money from a Roth IRA.
You can generally withdraw money contributed to a Roth IRA at any time. Why? Because you already paid tax on that contribution. If you’re more than 59 ½, you won’t pay taxes on any investment gains in the account either. Keep in mind that a five-year rule applies to Roth IRAs. This requires you to wait five years after your first contribution to a Roth IRA to withdraw your earnings tax-free. If you complete Roth conversions, a separate five-year rule applies to each conversion.
Unless you believe in Modern Monetary Theory (MMT), you probably expect tax rates to increase in the future. (In short, MMT argues that if a country issues its own currency, it will never “run out of money” the way a person or business can. Why? Because it can print more money.
At the same time, absent any changes to current tax law, tax rates will increase in 2026 unless Congress takes action before then. The lower tax rates that took effect in 2018 expire at the end of 2025. After that, we go back to 2017 rates.
Benefits of a Roth IRA
- Tax-free withdrawals. Roth IRAs do not provide a current tax benefit as you contribute after-tax dollars to your account. But withdrawals are tax-free. If you think your tax rate in retirement will be higher than it was while you were working, you should consider a Roth IRA. Two factors could drive this:
- You expect to make more money in retirement than you did while working. Yes, this is possible if you save diligently and invest well while you’re working.
- You expect tax rates to increase.
- Roth IRAs can reduce how much you pay in taxes on your Social Security benefits. Depending on how much money you earn in retirement, the amount of your Social Security income that is subject to current taxes can range from 0% to 85%. This is based on your provisional income. To calculate provisional income, you start with all income that would normally be taxed. You then add non-taxable income such as municipal bond income plus one-half of your Social Security benefits. (See this blog for more information on the taxation of Social Security income.) Since you don’t pay taxes on money withdrawn from a Roth IRA, such withdrawals do not count as income.
- Roth IRAs can decrease your Income Related Monthly Adjustment Amount (IRMAA). Unless you’re still covered by an employee healthcare plan, you can expect to enroll in Medicare at age 65. Your Part B premiums are based on your income. Not your current year’s income though. Instead, they get based on your tax return from two years ago.
For example, the premiums retirees are paying in 2021 are based on their 2019 income. If your income exceeds $88,000 (single) or $176,000 (married), you will pay more for Medicare than someone who makes less. There are another four brackets above this initial one. Once again, Roth withdrawals do not increase your income for purposes of determining your Medicare premiums.
Note that because Medicare premiums are based on your income from two years ago, you can be assessed a higher premium when you first retire. You can file an appeal if you believe your IRMAA is incorrect for a qualifying reason. As discussed in more detail here, work stoppage is one of the seven qualifying life-changing events that can allow for a redetermination of your Part B premium.
- You don’t have to take required minimum distributions (RMDs) from a Roth IRA beginning at age 72. You must, however, take RMDs from a Roth 401k or a Roth 403b. You can get around this requirement if you transfer the money to a Roth IRA.
- You can access money in a Roth IRA before age 59 ½ if you need it. Ideally, you want to save any money you deposit in your Roth IRA until retirement. But if you need it, you can withdraw money you contribute to a Roth IRA tax-free at any age. Your contributions also come out before any investment gains, so you don’t have to worry about figuring out how the withdrawal should be treated. You do have to track your contributions. If you need to withdraw more money than you contributed, you will have to pay taxes and penalties.
This feature makes Roth IRAs an attractive option for those that are not sure if they can leave the money they contribute to their account in place until they reach retirement.
- You can leave tax-free assets to your heirs. This benefit has significant value to those who have children or other beneficiaries who are high earners. Any distributions they receive from a traditional IRA get added to their other taxable income. They then get taxed at their highest marginal tax rate.
The SECURE Act made this benefit of Roth IRAs more significant. Under prior law, RMDs from an inherited IRA were based on the beneficiary’s life expectancy. The SECURE Act limits the withdrawal period for Inherited IRAs to 10 years. This limit applies to both Inherited traditional IRAs and inherited Roth IRAs. (Note that an exception exists for spouses and certain other beneficiaries.)
- You can start a Roth IRA for your child or grandchild to give them a great head start on building their retirement savings. For example, say that your child or grandchild gets a summer job. If they have earned income, they can open an IRA. It doesn’t matter how old they are. But the money doesn’t have to come from them. You can help them open the IRA. You can deposit money into their account. You could do this through an outright gift. You could also create a matching program. Tell them that for every dollar you put in the account, You’ll match it. You could double it, too. Remember that some limitations apply. The maximum contribution is $6,000 a year. You also can’t contribute more than they earn.
Some Changes to Roth IRA Rules Could Be Coming
Proposed tax legislation is only proposed legislation. It doesn’t mean anything until it passes into law. When I worked for Deloitte as a tax professional, I got used to seeing the same routine every year. New tax legislation would be proposed. The “think tank” members of the firm would write about what the legislation could mean and what steps you could take. Then the legislation didn’t pass. Or if it did pass, it would be different in some respects than what was originally proposed. The lesson I learned was to follow the path of proposed legislation. But be careful about acting on it before it was signed into law.
As noted above, the tax legislation proposed in September was targeted towards some elements of retirement savings accounts:
- Backdoor Roth IRAs – or Mega-Backdoor Roth IRAs – would no longer be allowed after this year.
- Roth conversions for high-income taxpayers might not be allowed beginning in 2032.
- High-income taxpayers and those with huge retirement accounts would have to take increased RMDs.
To learn about some other tax provisions that would impact financial plans, please check the beginning of this blog.
If you have questions about Roth IRAs or would like some help determining if they might be right for you, please schedule a free call. I would be happy to discuss them. To do so, you can either send me an email at firstname.lastname@example.org or schedule a free call using this link.
I’ll be back next week with “Apprise’s Five Favorite Reads of the Week.”
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Phil Weiss founded Apprise Wealth Management. He started his financial services career in 1987 working as a tax professional for Deloitte & Touche. For the past 25+ years, he has worked extensively in the areas of financial planning and investment management. Phil is both a CFA charterholder and a CPA.
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