The Basics of a ROTH

A Roth IRA is a special retirement account that you fund with after-tax income (you pay taxes on the funds at ordinary federal and state rates).  Then you can invest that money without having to pay any capital gains tax on the growth of your investments.  All future withdrawals that follow Roth IRA regulations are tax-free.  In order for distributions to be made on a tax-free basis, the account owner must be age 59 ½ or older, have become disable or are deceased.  They must have had at least one ROTH IRA open for five years or more (time starts on the first day of the tax year that you make your initial contribution to your first ROTH account). If you withdraw earnings before 59 ½ or within five years of opening the account, you will pay a penalty worth 10% of your withdrawal. Any earnings you withdraw are included as regular income on your taxes that year.

There are a few situations when ROTH IRA earnings can be withdrawn penalty-free:

  • Unreimbursed medical expenses exceeding 7.5% of your adjusted gross income.
  • Using your distributions to pay qualified higher education expenses.
  • You took the distribution as part of the IRS seizing your account.
  • The distribution was taken by a qualified military reservist.
  • You are deemed totally and permanently disabled by the government.
  • You are the beneficiary of an IRA.
  • You used your distributions to pay health insurance premiums due to unemployment (includes COBRA coverage).
  • You are a first-time homebuyer and use the funds to buy, build or rebuild a first home.
  • You receive distributions in the form of an annuity.

Unlike a traditional IRA, you don’t have to start taking annual required minimum distributions (RMDs) from these accounts at age 72.   A Roth also allows you to segregate your qualified retirement money into high growth and low growth investments, such as bonds vs equities.  You would put your high growth investments into your Roth as they would grow and never be taxed.  Your bonds you would keep in your regular IRA and you would pay taxes on the interest as you make withdrawals.

You can only open and contribute to a ROTH IRA if you have earned income.  Earned income does NOT include unemployment benefits, Social Security benefits, investment gains, or interest in a savings account.

Contribution and Income Limits for 2021

The contribution limit for a ROTH IRA in 2021 is $6,000 if you’re age 50 or younger and $7,000 if you’re older than age 50.  You can contribute to a Roth account at any age as long as your annual income (MAGI) is within the income limits for your filing status.

Income limits in 2021 for opening a ROTH IRA depend on your tax filing status and your annual income:

INCOME LIMITS    
Filing Status Max Income for Partial Contribution Max Income for Full Contribution
Single $140,000 $125,000
Married filing jointly $208,000 $198,000
Head of Household $140,000 $125,000
Married filing separately $10,000 You cannot contribute the max
Qualified Widow(er) $208,000 $198,000

 

If your income exceeds the Roth IRA income limits, you may be able to contribute through a “backdoor Roth IRA,” which is a once-per-year conversion from a traditional IRA.  Keep in mind, you’ll pay taxes on your conversion.  Doing a conversion prior to year-end will yield a larger federal income tax bill for the current year and possibly a larger state tax bill too.  Due to the rate of return being higher for a ROTH IRA as a result of no taxes being due on any gains in a ROTH IRA, it typically makes more sense to use taxable assets as opposed to proceeds from a converted account to pay the tax cost associated with a ROTH IRA conversion.  One strategy that has been used by many is to spread the cost of the conversion over a few years.  This may avert you from being pushed into a higher tax bracket.  Another option for those who exceed the Roth income limits is to consider a traditional IRA, which has no income limits.

When Does a ROTH Make Sense?

  • Generally, ROTH IRA conversions are ideal for those who believe their tax rates during retirement will be the same or higher than their current tax rates. Young people in their 20’s and 30’s who are just starting out in their careers are one segment of the market who could benefit since their income and tax rates will likely rise higher in later years.
  • If you decide to move to a different state in retirement and that state has a higher state income tax rate, it may make sense to explore. If you plan on moving to a state that excludes retirement income or has a lower state income tax rate, a Roth may not be as advantageous.
  • If you want to leave the money to heirs, ROTH IRAs can be beneficial since they don’t incur income taxes and the income taxes paid on a Roth conversion may help reduce the size of a taxable estate.
  • If you can live off long-term capital gains from a taxable account in the first few years of retirement and convert an amount in the lower tax brackets from your IRA to a ROTH each year, you’ll manage to end up with a relatively low effective tax rate in retirement.
  • If you can delay taking Social Security benefits, ROTH IRAs can be beneficial. Since you may not have any other sources of income, the first few years of retirement may be an ideal time to take those ROTH withdrawals.  When you withdraw from a ROTH IRA late in retirement, it won’t affect how much of your Social Security benefits get taxed.  Tax on Social Security benefits is based on combined income, which is the sum of half your Social Security benefits, adjusted gross income, and non-taxable interest.  ROTH IRA distributions don’t count toward your combined income like traditional IRA distributions do.

ROTH IRAs are not for everyone.  They are one of many tools that can be used in structuring someone’s retirement.  Meeting with a registered financial advisor and/or CPA is recommended.  They can help review your current and projected income tax bracket, estimate your anticipated tax burden based on your retirement income plan, assist with weighing the pros and cons of a given strategy, and apply it to your individual circumstances.  Please give us a call at 410-824-1853 or visit us at www.geierfinancial.com.

Sources: Forbes/ Money and Markets/ USA Today/ Policy Genius/ Motley Fool

© Geier Asset Management, Inc. March 2021. Gregory Palacorolla, CFP ® is Director of Wealth Management for Geier Asset Management, Inc., a Registered Investment Advisor. The articles & opinions expressed in this material were gathered from a variety of sources, but are reviewed by Geier Asset Management, Inc. prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of March 2021 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual circumstances. In all cases, please contact your investment professional before making any investment choices. Geier Asset Management, Inc. is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.