You can’t read a book or website nowadays without someone talking all about how amazing and awesome a ROTH IRA or 401k is. And yes, they can be awesome. After all, you put in after-tax money, it grows tax free, and you can get tax-free withdrawals! They also have advantages when it comes to required minimum distributions (as in, they don’t have any) and inheritance. Indeed, the ROTH can be a powerful tool-but it’s not always the best choice.
“How could it not be the best choice, CMO?” you might be thinking. After all, you can take out your contributions any time! The tax man can’t come and get your gains! But like any investment decision, you need to make sure that you’re making the right choice for you, in your specific situation. And in some situations, a ROTH can be a bad-or downright terrible- idea.
When you’re making investment choices, beware of anyone that touts a specific investment option or vehicle as perfect for everyone, in every situation, all the time. If you read an article and that’s the impression you get, I must insist that you dig deeper. You’re going to find drawbacks and exceptions to the “rules” someone may have put forth in a simple article. When it comes to investing, there is no one-size-fits-all, perfect opportunity. This is something I’ve learned over my twenty years of seeking financial freedom.
Today I’m going to talk all about the great parts of the ROTH. Later this week I’ll do the bad and the ugly. This started as a single article but got way too long, so I broke it into three parts. so read on to hear all about the good, and stay tuned for the bad and the ugly.
What Is A ROTH IRA or 401k?
If you’re newer to the investing scene, you might not be familiar with the ROTH. Or perhaps you’ve heard of it but can’t quite remember what it is. A quick, basic refresher (and some resources to go learn more):
- It was named for Delaware Senator William Roth, and was established by the Taxpayer Relief Act of 1997. Note – this would be why my parents didn’t use a ROTH when they helped me open my first IRA as a teenager. It either didn’t exist or was brand new, depending on what year you’re talking about. Nowadays I will use a ROTH when I make the same offer to my kids.
- You put in after-tax money, it grows tax free, and withdrawals are tax free under specific circumstances. What are those?
- For ROTH IRA’s, contributions can be withdrawn tax-free once your account is five years old
- ROTH 401k’s, withdrawals are subject to the rules of your custodian. For example, mine does not allow in-service withdrawals (withdrawals that occur while you’re still working for your employer). So make sure to check with them before you count on this
- After age 59.5, just like a traditional IRA
- You can keep contributing to a ROTH as long as you have earned income – income from some sort of job. Not just social security and investment withdrawals.
- You can convert traditional or after-tax IRA’s into a ROTH. The after-tax ROTH conversion is sometimes called a backdoor ROTH, because it can be used by people who exceed the usual ROTH income limits
Learn More on:
- Investopedia – The ROTH Basics
- Define Financial Traditional vs. ROTH Evaluation
- Mad Fientist – ROTH Conversion Ladder
- IRS – ROTH IRA Rules
ROTH – The Good
I love a lot of things about ROTH IRA’s. Here are the advantages that you’ll often read about online, in books, and in magazines.
- Tax Free Gains and Distributions-Yes, it’s true. When you put money into a ROTH IRA or 401k, it grows tax free. As long as you follow the rules for withdrawals, you can take out your contributions tax-free anytime (its after five years before you can take the earnings) and can definitely take them out when you hit 59.5.
- Tax Free (Or Low Tax) Conversion Opportunity – Lets say you have a traditional IRA or 401k, and you’re laid off. Or you decide to start your own business, and your income takes a hit for a year or two. Perhaps you decide to retire early and live off savings and investments for a while. Whenever your income is low, you can take advantage of the lower tax bracket you’re in by converting some money into a ROTH that year. You do pay taxes, but it will be at a lower rate (hopefully) than you’ll be in later. Or in the case of an early retiree, it will be at a lower rate one-time, and then you can let the ROTH compound while you spend from other sources of money for a while.
- Low Earning Years – When you’re young and earning less than you will later in life-say, a teenager or just out of college – you can’t beat a ROTH. Why? You know for a fact that your tax rate is lower now than it will be as your career progresses. So you pay a smaller amount of taxes now to avoid a larger amount of taxes later. Bill from Famzoo agrees with this, and outlines a strategy to open a ROTH IRA for your working teenager.
- Withdraw Contributions Anytime… – When you’re a teenager or just starting out in the workforce, you might be hesitant to start saving for retirement. After all, you probably don’t have a lot of money at that point in your life. The ROTH helps with this by letting you withdraw contributions anytime (sort of – check out The Bad section for the exception)
- Required Minimum Distributions (RMD’s)– ROTHs don’t have RMD’s. This is a great advantage, since people who have accumulated a lot of traditional IRA/401k money tend to get hit with RMD’s starting at age 70.5. If you don’t take your RMD, you get hit with a 50% penalty. So if you want a fund for your later-in-life years, a ROTH is an amazing option.
- Backdoor For High Earners– ROTH contributions are limited to those earning under a certain limit. If you’re single, your modified adjusted gross income must be less than $133,000 as of this writing (2017), and contributions are reduced starting at $118,000. If you are married, your MAGI must be less than $196,000, with reductions beginning at $186,000. You can get around this limit by using the “backdoor”, where you contribute to an after-tax IRA and then immediately convert it into a ROTH. You’ll be taxed on any gains, but if you do the conversation immediately (or put your money in the after-tax IRA into a money market fund that won’t grow) you’ll likely owe nothing.
- Tax Rate Diversification– If you put all your financial eggs in the traditional IRA basket, you’ll be forced to pay taxes on all your withdrawals. By spreading your money in between a traditional and a ROTH, you can decide based on your income to withdraw from one or the other depending on your specific financial circumstances. Tax diversification is an important consideration in retirement, and it can’t hurt to have your financial eggs spread in multiple tax baskets.
- Inheritance– Inheriting a ROTH can be great. Not only did you not have to take any RMD’s, meaning that your ROTH could continue to grow and compound through your lifetime, but also your heirs don’t have to pay taxes. If you’re in a low tax bracket and your heirs are in a much higher one, this can be a real advantage over inheriting a traditional IRA. When you inherit a traditional IRA, you need to pay taxes at your rate. Often your rate is higher than the person you inherited it from, particularly if they were retired with little earned income. So inheriting a ROTH can be very beneficial (there is a gotcha, though-check out the ugly for the one downside).
So A ROTH IRA Is Good, Then?
After reading all about the good parts of a ROTH, maybe you’re sold. You think that it’s a must have! Not so fast. Be sure to stay tuned to Part 2-The Bad and Part 3 – The Ugly for a balanced view of the ROTH option.
Let me know in the comments – did I miss any advantages to a ROTH? What’s your favorite one?
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