2/20/2014 4:00 PM ET|
10 things to know about Roth accounts
Creating a tax-free stream of income is a powerful retirement tool. Here's the scoop on Roth IRAs and 401k's.
Tax-free income is a dream of every taxpayer. And if you save in a Roth account, it's a reality. Roths are the youngsters of the retirement savings world. The Roth IRA, named after the late Delaware Sen. William Roth, became a savings option in 1998, followed by the Roth 401k in 2006. These accounts offer big benefits, but the rules for Roths can be complex. Here are ten things you must know about adding a Roth to your nest egg.
You pay Uncle Sam now instead of later
Roths turn traditional IRA and 401k rules on their head. Rather than getting a tax break for money when it goes into the account and paying tax on all distributions, with a Roth, you save after-tax dollars and get tax-free withdrawals in retirement.
By accepting the tax breaks for traditional accounts, you accept the government as your partner. If you're in the 25% tax bracket, for example, 25% of all earnings will effectively belong to the IRS to be collected when you withdraw the money. With a Roth, 100% of all future earnings are yours.
The Roth strategy of paying taxes sooner rather than later will pay off particularly well if you're in a higher tax bracket when you withdraw the money than when you passed up the tax break offered by the traditional account. If you're in a lower tax bracket, though, the Roth advantage will be undermined.
There are limits contributing to a Roth IRA
To be able to contribute to a Roth, you must have earned income. And unlike traditional IRAs, if you're still working after age 70 1/2, you can keep contributing.
In 2014, you can stash up to $5,500 in a Roth IRA and an extra $1,000 if you're 50 or older.
But higher-income taxpayers are barred from contributing to a Roth IRA. For 2014, the ability to contribute to a Roth phases out if your adjusted gross income is between $181,000 to $191,000 for joint filers and between $114,000 to $129,000 for single filers.
You can make a 2013 Roth IRA contribution as late as April 15, 2014. You can contribute to both Roth and traditional IRAs, but the total cannot exceed the annual limit.
Your company may offer a Roth option
Many companies have added a Roth option to their 401k plans. After-tax money goes into the Roth, so you won't see the immediate tax savings you get from contributing pretax money to a traditional plan. But your money will grow tax-free. (Any employer match will go into a traditional 401k account.)
For 2013 and 2014, you can stash up to $17,500 a year, plus an extra $5,500 a year if you're 50 or older, into a 401k. Contributions must be made by December 31 to count for the current tax year, and the limit applies to the total of your traditional and Roth 401k contributions. A Roth 401k is a good option if your earnings are too high to contribute to a Roth IRA.
You can do a Roth conversion
Another route to tax-free earnings inside a Roth is to convert traditional IRA money to a Roth. In the year you convert, you must pay tax on the full amount shifted into the Roth. That's the price you pay to buy tax freedom for future earnings. (If you have made nondeductible contributions to your traditional IRA, a portion of your conversion will be tax-free.)
If you expect your tax rate to be the same or higher in the future, converting could make sense; if you expect your future tax rate to be lower, it might not.
You'll want to pay the tax owed on a conversion with money outside of the IRA. Drawing money from the IRA to pay the tax will result in an additional tax bill, and a penalty if you're under age 59 1/2.
A conversion could trigger other tax events
Look at the big picture if you plan a conversion. The added taxable income could boost you into a higher tax bracket. A big jump in income could trigger other taxes, too, such as the new 3.8% surtax on net investment income. For Medicare beneficiaries, a rise in adjusted gross income could result in premium surcharges for Part B and Part D.
A series of small conversions over several years could keep the tax bill in check. For instance, you may want to convert just enough to take you to the top of your current tax bracket.
You must pass the tests for tax-free earnings
Because there's no tax deduction for Roth contributions, you can retrieve that money at any time free of taxes and penalties, regardless of age.
But for earnings to be tax- and penalty-free, you have to pass a couple of tests. First, you must be 59 1/2 or older. You will get hit with a 10% early-withdrawal penalty and taxes if you take out earnings before you hit age 59 1/2. And you must have had one Roth open for at least five years. If you are 58 and opening your first Roth IRA in 2013, you can tap earnings penalty-free at age 59 1/2, but you won't be able to tap earnings tax-free until 2018.
There's a different rule for conversions. Read on.
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There are 2 5-year rules
If you make a conversion, you must wait five years or until you reach age 59 1/2, whichever comes first, before you can withdraw the converted amount free of the 10% penalty. Each conversion has its own five-year holding period. So if a young account owner does one conversion in 2013 and a second conversion in 2014, the amount from the first conversion can be withdrawn penalty-free starting in 2018 and the amount from the second starting in 2019.
Earnings on a converted amount can be withdrawn tax- and penalty-free after the owner reaches age 59 1/2, as long as he or she has had any Roth IRA opened at least five years.
There's an order to withdrawals
The rules for determining the source of money coming out of a Roth work in the taxpayer's favor. The first money out is considered contributed amounts, so it's tax- and penalty-free. Once contributions are depleted, you dip into converted amounts (if any). This money is tax- and penalty-free for owners 59 1/2 and older or younger ones who have had the converted amount in a Roth for more than five years. Only after you have cashed out all converted amounts do you get to the earnings. Once the account owner is 59 1/2 and has had one Roth for at least five years, earnings, too, can be withdrawn tax- and penalty-free.
The ability to tap money in a Roth IRA without penalty before age 59 1/2 allows for flexibility to use the Roth IRA for other purposes. For example, the account could be used as a fallback for college savings.
Once you reach retirement, having a pot of tax-free income to draw upon may allow you to lower your tax bill. Roth money doesn't count in the calculation for taxing Social Security benefits, for example, or in the calculation for the new tax on investment income.
You can take a mulligan
Roth IRA conversions come with an escape hatch. If you converted $50,000 but the Roth is now worth $35,000, you would still owe tax on the $50,000. Undoing the conversion—known as a recharacterization—wipes away the tax bill. Recharacterizing can also pay off if you can't afford the tax bill or the conversion unexpectedly pushes you into a higher tax bracket.
You have until Oct. 15 of the following year to undo a conversion. So a 2013 Roth IRA conversion can be reversed up until October 15, 2014.
But note: While you can now convert a traditional 401k to a Roth 401k within a company plan, an in-plan conversion cannot be reversed.
A Roth can benefit heirs
Unlike traditional IRA -- which you must begin to tap at age 70 1/2 -- Roth IRAs have no minimum distribution requirements for the original owner. So, if you don't need the money, it can grow in the tax shelter until your death. If your spouse inherits the account, he or she never has to make withdrawals, either.
If the Roth IRA passes to a nonspouse heir, the rules change. They are required to take minimum distributions starting the year following the death of the original owner, or empty the account within five years of the account owner's death. Distributions, though, will still be tax-free and can be stretched over the beneficiary's life expectancy. A young child or grandchild who inherits a Roth has the potential for decades of tax-free growth.
Wealthy taxpayers may find another estate-planning advantage to a Roth conversion. The taxes paid on a Roth conversion will be removed from their taxable estate.
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It also means you have to hope for the next 40-50 years that Congress doesn't install a National Sales tax or Consumption tax.
If Congress does, you'll get taxed again when you spend that Roth money (and many won't even realize it).
I put in a little into the Roth to start the 5 year waiting period, but I'll max out the traditional first (and get the tax deduction now, while it still exists).
Then, put in any extra (if you have it) into the Roth, hoping to God the laws don't change in the next century.
The real advantage of the Roth is that there is no mandatory distribution. So, unlike a Traditional IRA, in which you must start receiving mandatory distributions at 70 1/2 years old. So as an example, If you have been prudent and through the years contributed to your traditional IRA and with gains and dividends grew to lets say, 2 million dollars, you will get an automatic distribution every year after 70 1/2 years old starting at 80,000. In this example, this mandatory distribution would be added to any other form of taxable income you had, and you could potentially see your tax bracket shoot up many levels. This is a huge burden on many taxpayers when unexpected and causes large tax bills and penalties if you are not prepared. That, I believe is why a Roth is superior, since you dont have mandatory distributions, and as long as you have owned it for 5 years and are 59 1/2 years old you can choose to take out your tax free money any time you wish or even leave the entire amount for a rainy day or for your heirs. Hope that helps
Why provide loop holes and deduction within the tax code instead of just lowering the tax rate or collecting the same tax equally to everyone?
Just more ways for politicians to cater to their voting blocks and discriminate among US citizens.
1) Currently the income is tax-free, but are you sure that it will be when to want to with draw it?
2) Why are there income caps on who can contribute to this program since the tax has already been paid when the money is earned? So if you make to much to contribute this year but are suddenly unemployed you do not have any retirement savings to rely on unless you were responsible enough to save.
3) Why is there a way to reduce taxes when the government really wants the tax money to redistribute it to those who can not take advantage of these programs?
No all of these tax loop holes, deductions, and credits should be eliminated. If an equal tax can not be instituted then at least the need for accountants and lawyers to fill out tax forms and figure out ways to avoid taxes should be eliminated. Thereby eliminating another ability of politicians to cater to their voting blocks through the use of the tax code.
Sit down with an excel spreadsheet and run the numbers. Assuming only $5500 (the IRA max) to invest each year, you will pay less taxes with the Roth than with the traditional IRA.
In the tradition IRA you would invest the whole $5500 each year. With the Roth you will invest $4125 each year after taxes. Assuming a 25% tax.
At retirement at age 68 you will have $1,307,275 with the Traditional IRA. At retirement at age 68 you will have $980,456 with the Roth IRA. Assuming a 5% annual return.
With the Traditional IRA you will be able to withdraw $78,786 each year, but $19,695 will be used to pay taxes. Leaving you with $59,091 to live on. You can withdraw this annual amount until age 100 before you run out of money.
With the Roth IRA you will withdraw $59,091 each year and pay no taxes. You can withdraw this annual amount until age 100 before you run out of money.
The difference comes when something bad happens. Unforeseen medical expense and/or nursing home. For each $50,000 of additional medical expense you will need to withdraw a total of $66,665 to cover the expense and the taxes with the Traditional IRA. With the Roth you only need to withdraw the $50,000 to cover the expenses and pay no taxes. Your money will last longer under with the Roth IRA. At age 100 you will have a negative $274,433 with the Traditional IRA and a negative 205,866 with the Roth.
Total taxes paid with the Roth IRA $74,875.
Total taxes paid with the Traditional IRA $646,906
In the end the Roth helps you deal with the unexpected.
I do a simple thing twice a year and my conversions our free...and I make more money!
I take 2/ $3200 401K loans each year (2 is all I am allowed) for a 1 year period. I am charged %4.25 persent on the loans, but the interest is given back to me! I then take the $3200 and buy stocks and bonds into my ROTH IRA. I am a self investor and got rid of my broker after he started asking me "what to buy". I am lucky to have a solid investment mind. I am self taught and anyone can learn to do it for yourself. With this strategy I have returned over 10% in profit each year for the last 10 years.
I only buy income vehicles that pay 4-12%. I use a sharebuilder ROTH and have 200 different positions. I started with 1 or 2 shares of each, so I could now see what is up and what is down without lengthy reseach each week. I cann see what is cheap each week by looking at my small holdings. So each week I get the best buys possible.
Learning to trade has been the answer to my dreams, and where I learned how to trade because I've never traded before is a place called Bionic Traders. These guys are great so helpful to a new trader like I was, if you get stuck with something or need help they are there to help you and very knowledgeable in trading. So I tell people stop working for somebody else and work for yourself, just learn to trade.
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