Saving for retirement is a goal that you should tackle as early in life as you can. Why? A couple of reasons. 1- the power of compound interest; 2 – You can’t borrow for retirement. You can borrow for a home, a car, a wedding, or to go to college, but you can’t borrow to pay for your retirement. Why? How would you pay it back?! Starting to save and invest early and often is important to secure your future. Saving money on taxes along the way makes it even better. There are several types of tax efficient retirement accounts including the 401(k), Health Savings Account (HSA), Individual Retirement Accounts (IRA’s) and a few others. There are two principal types of IRA: traditional and Roth.
A Roth IRA is funded with after-tax dollars. Unlike traditional IRAs, there are no current year tax benefits but your contributions and earnings can grow tax-free, and you can make withdrawals tax and penalty-free in retirement (technically after age 59½ and once the account has been open for at least five years.) Compare that to a regular brokerage account which also starts with after tax money; with a brokerage account you have to pay taxes on any realized gains/dividends every single year. A Roth’s investments grow without being taxed, assuming you follow the rules.
When choosing between a traditional and Roth IRA the basic idea is that if you think your tax rate is lower now than it will in retirement, Roth is the way to go. Start investing now and let it grow tax free for many years to come. The Roth option has become increasingly popular in recent years due to the cuts in tax rates. Here is a high level summary of how a Roth IRA works:
|Who can contribute||You can contribute at any age if you (or your spouse when filing jointly) have earned income and your modified adjusted gross income is below a certain amount. If filing jointly, you and your spouse can both contribute to your own separate IRA’s, even if the spouse has no income (spousal IRA).|
|Are my contributions tax deductible?||Your contributions are NOT deductible. They are after-tax.|
|How much can I contribute?||For 2019 and 2020: up to $6,000 or $7,000 if you’re age 50 or older. These amounts may be adjusted annually.|
|What is the deadline to make a contribution?||Your tax return filing deadline (typically April 15th), not including extension.|
For example: You can make 2019 IRA contributions until 4/15/2020*, the date your 2019 taxes are due.
*Due to COVID-19, this deadline has been extended to July 15, 2020.
|When can I withdraw my money?||You can withdraw contributions made to your Roth IRA anytime, tax and penalty-free (since you’ve already paid taxes on them). However, if you withdraw early from your Roth IRA you may have to pay taxes and penalties on the earnings.|
|Am I required to take distributions?||Distributions are not required if you are the original owner. Your beneficiaries, other than a surviving spouse, must take distributions within a certain time period. A surviving spouse will transfer the assets to their own Roth IRA (existing or new) and will be subject to the same distribution rules as if they were the original owner.|
|Are my withdrawals and distributions taxable?||“Qualified withdrawals” are tax and penalty-free. Roth IRA withdrawal and penalty rules vary depending on your age, how long you’ve had the account and other factors. Basically, if you wait long enough withdrawals should be tax free.|
|Where can I open a Roth IRA?||You can open a Roth IRA at most banks, credit unions and other financial institutions. They are also available through online brokers, investment and mutual fund companies.|
One final tip, if your income is too high to qualify for a Roth IRA, the IRS has approved a common practice referred to as the “back door Roth”. Since traditional IRAs don’t have an income limit for contributions, and traditional IRAs can be converted into Roth IRAs, individuals can fund a traditional IRA with nondeductible contributions, and then convert the account into a Roth IRA. There are a few things that can complicate this (already owning an IRA, timing of conversion, etc), so talk with a financial adviser to see if you are eligible. For more details on income limits, qualified withdrawals, the full rules and exceptions, check out the IRS website or ask a BrightDime coach.