Written by: Greg Palacorolla, CFP®
An individual retirement account (IRA) allows individuals to have tax free growth, customized investment choices, and the ability to directly rollover old 401(k)’s. Tax free growth is one of the most necessary ingredients for compounding growth and long-term wealth accumulation. Therefore, in addition to funding your workplace retirement plan, individuals and families should contribute to an IRA before investing in a taxable account. The annual limits for contributions are $5,500 if you are under age 50 and $6,500 if you are over the age of 50. To be eligible to contribute to an IRA you must have earned income (if one spouse works you can still do a spousal contribution but your income needs to be at least the amount of the contribution).
Roth IRA vs. Traditional IRA
The key differences between a Roth and Traditional IRA are that Roth’s allow you to withdrawal contributions at any time without penalty, contributions are made with after-tax income, they are not subject to RMD’s, contributions can be made until age 70, and at age of 59.5 withdrawals on earnings and contributions are income tax free. Yes, withdrawals are income tax free in retirement! In contrast, Traditional IRA’s are fully taxable when you withdrawal funds after age 59.5. Also, there is a 10% penalty plus income tax if you withdrawal funds prior to the age of 59.5 and do not deposit those funds back into the IRA within 60 days. That said, given the flexibility of the Roth it is important that every household or individual understand if they are eligible to contribute to a Roth as well as the best way(s) to maximize their contributions.
For individuals, the maximum annual contribution to a Roth IRA is phased out with an adjusted gross income (AGI) from $117,000 to $132,000 for 2016. For married couples filing jointly, the maximum contribution is phased out with an AGI from $183,000 to $194,000 for 2016. If your individual or joint income falls below these aforesaid AGI phase outs you can certainly contribute $5,500 or $6,500 by April 15, 2017 for your 2016 contribution. However, what is the best strategy to follow if you want to contribute more to your Roth IRA or if your income level phases you out of Roth eligibility?
Roth IRA Strategies
If you want to contribute more than $5,500 to a Roth, an indirect strategy would be to contribute after-tax money to your employers defined contribution plan (401(k), 403(b), 457, TSP, etc.). Once you separate from service or retire from the workforce you can do a direct rollover to a Roth IRA with your after-tax contributions to your retirement plan. For example, if your 401k plan has $100,000 with $20,000 being from after-tax contributions you will have the option to do a direct rollover of $20,000 to a Roth IRA once you retire or separate from service. Another strategy you could follow if your AGI precludes you from contributing to a Roth IRA would be to consider doing a Roth conversion with a Traditional IRA account (see backdoor IRA blog). This strategy entails transferring funds from a Traditional to a Roth IRA. However, any gains will be taxable in the given year. It is important before making this election that you discuss with a tax consultant to properly plan for any income tax liability.
Every household should explore the possibility of investing in a Roth IRA because of its simplicity and growth potential if allocated properly. From a planning perspective one of the biggest headwinds that individuals have managing their tax liability and with that it becomes impetrative to seek strategies that can help manage the income tax that you pay. No other investment account can offer the investment variety and tax benefits than the Roth IRA.
At GAM, we are available to discuss all of your options and assist you in any way. Please give us a call.