Two of the greatest financial mistakes made by high earners include failing to save enough for retirement and failing to take full advantage of tax-sheltered accounts. Fortunately, one solution can help with both problems: the Roth IRA.
Named after the late United States senator William Victor Roth Jr., who sponsored the bill that created this account, Roth IRAs combine flexibility with tax savings. The catch? You don’t see those tax savings now, but rather after you retire.
As you plan your retirement investments, make sure you understand the Roth IRA, because it forms a core option in your investing toolkit.
What Is a Roth IRA?
A Roth IRA is a type of individual retirement account (IRA). It allows you to set aside a certain amount of money each year for retirement, with special tax treatment.
Unlike with traditional IRAs that let you deduct the contribution from this year’s taxable income — lowering your taxes immediately — you still pay taxes on the money you contribute to a Roth IRA. But your contribution then grows tax-free, and you pay no income taxes on money you withdraw from the account in retirement. That lowers your tax bill in retirement, which in turn reduces the amount you need to save for retirement.
You can open and manage both traditional IRAs and Roth IRAs through a regular free brokerage like M1 Finance or TD Ameritrade. Which means you maintain full control over your investments, and can invest in any paper assets — stocks, bonds, ETFs, commodity funds, and so forth — allowed by your brokerage.
It also means you completely own and control the account, unlike employer-sponsored retirement accounts like 401(k)s. You don’t have to change Roth IRA accounts each time you change jobs — you can keep the same account for your entire life.
Pro tip: If you’re investing in a Roth IRA (or any other retirement account), make sure you sign up for a free portfolio analysis from Blooom. They will make sure your portfolio is properly diversified and has the correct asset allocation. They’ll also check to see that you’re not paying too much in fees.
Benefits of a Roth IRA
Roth IRAs come with a wide range of benefits, some of which might surprise you.
Keep the following in mind as you plan your approach to retirement investing through tax-sheltered accounts, because Roth IRAs should play a role in everyone’s retirement strategy.
Tax-Free Compounding & Withdrawals
In a traditional IRA, you get to deduct the contribution now, but you pay taxes on withdrawals in retirement. That means you pay taxes on your gains too.
With Roth IRAs, you pay income taxes once on the contribution, but never have to pay another cent in taxes on funds in the account. Your money grows and compounds tax-free, and you avoid paying taxes on withdrawals in retirement.
To begin with, this prevents your taxes from going up in retirement. Most people assume they’ll pay less in taxes in retirement, but that makes for a dangerous assumption. Income tax rates may well rise in the years to come, and even if they don’t, you probably plan to be wealthier at the end of your career than you are today.
Then there’s the compounding. Imagine you set aside $500 per month for retirement for 30 years, and earn an average historical stock market return of 10%. After 30 years, you will have contributed $180,000 — but your ending balance would be $986,964.
If you invested through a taxable brokerage account, you’d pay income taxes on the contributions and the returns. If you invested through a traditional IRA, you’d dodge the taxes on the $180,000 in contributions initially, but you’ll pay taxes on both the $806,964 in returns and the $180,000 in contributions upon withdrawing them from the account.
But if you invested through a Roth IRA, you’d pay taxes only on the $180,000 in contributions, and avoid taxes on the $806,964 in returns, as well as on any additional returns you earn on your balance after you retire.
Early Withdrawal Flexibility
Account holders can withdraw contributions from their Roth IRA at any time, even before they reach 59 ½. After all, you’ve already paid your income taxes on those contributions.
This flexibility lets you contribute money to a Roth IRA without “fear of commitment.” If you end up needing the money for another purpose, such as buying a home or starting a business, so be it. You can pull it back out, no harm, no foul.
In contrast, the IRS imposes stiff penalties plus back taxes on early withdrawals from traditional IRAs.
Compatibility with Other Accounts
Even if you have an employer-sponsored retirement plan such as a SIMPLE IRA, 401(k), or 403(b), you can still contribute to a Roth IRA as long as your income doesn’t exceed the limit (more on income limits shortly).
That means many workers can still take full advantage of employer matching contributions, while also investing through their own Roth IRA. In 2020, a worker under 50 could theoretically contribute $19,500 tax-free to their 401(k) plus another $6,000 to their Roth IRA.
Full Control and Ownership
Employer-sponsored retirement accounts make a great employment benefit, allowing you to save and invest more money in tax-sheltered accounts than you’d be able to otherwise. But they also come with a few downsides compared to IRAs.
To begin with, you don’t actually own the account. You own the funds inside the account, but the account itself is managed by your employer. When you leave that job, you typically roll over the funds from your employer-sponsored account to either your IRA or to a new employer’s retirement account. It doesn’t take a degree in accounting to do, but it creates another step and barrier, and all too often employees forget about money left in old employers’ retirement accounts.
Another drawback to employer-sponsored retirement accounts is the lack of investment options. Most offer a handful of available investments, usually a few dozen at most. Compare that with the nearly limitless investment options available through an IRA account through your broker, where you can choose any stocks, mutual funds, and ETFs you like.
Bankruptcy and Asset Protection
Retirement accounts, including Roth IRAs, remain immune from most creditors. That means they can’t attach liens to them or garnish them if someone sues you and wins a money judgment. If you declare bankruptcy, most creditors can’t empty them to pay outstanding balances. One notable exception: the IRS. If you owe back taxes, expect no quarter and none of the normal asset protections.
Double Tax Protection With the Saver’s Credit
Uncle Sam doesn’t always play the role of Uncle Scrooge. The federal government knows the importance of retirement planning, particularly for lower-income earners. So they offer even more tax breaks for lower earners who contribute to retirement accounts.
Those with modest paychecks can qualify for the Saver’s Credit, which — as a tax credit rather than a tax deduction — comes straight off your tax bill. But the income limits are stringent: in 2020, single taxpayers can claim a tax credit of 50% of their contribution if they earn less than $19,500. If they earn $19,501 to $21,250 they earn a credit of 20% of their IRA contribution, and a 10% credit if they earn $21,251 to $32,500. Those earning more than $32,500 don’t qualify.
Married couples filing jointly can take a 50% tax credit if they earn less than $39,000, a 20% credit if they earn $39,001 to $42,500, and a 10% credit if they earn $42,501 to $65,000.
The fine print doesn’t end there. Even if you slip under the income limit, you must meet all the following criteria as well:
- You must be at least 18.
- You cannot be a full-time student.
- No one can claim you as a dependent on their tax return.
If you meet the requirements and contribute to a retirement plan such as a Roth IRA, however, you can qualify for a tax credit up to $1,000 (up to $2,000 for married couples filing jointly).
No Required Minimum Distributions
When you contribute to a traditional IRA, the IRS doesn’t get to skim their due off of your income. To make sure you don’t die without having paid taxes on this money, they force you to start taking distributions (withdrawals) from your IRA starting at age 72. Remember, they collect their taxes on the withdrawals, so they force you to take them.
These mandatory withdrawals are called required minimum distributions or RMDs. And they don’t apply to Roth IRAs, because you’ve already paid income taxes on your contributions. Therefore, the IRS doesn’t care if you never withdraw the money.
This in turn means you can withdraw money from Roth IRAs at your own speed — or not at all, if you want to leave it behind for your heirs.
Estate Planning Perks
Before the SECURE Act of 2019, beneficiaries who inherited a traditional IRA still had to take RMDs, but they could spread them out over their entire life expectancy. Now, beneficiaries must empty inherited IRAs within 10 years (known as the “drain-in-10 rule”).
Once again, it doesn’t apply to Roth IRAs. If you want to pass your Roth IRA along to your children, they too get to withdraw all funds tax-free (at least for contributions made at least five years beforehand). They can opt to take a lump-sum payout tax-free, or they can spread out tax-free distributions over the rest of their lives, following the life expectancy method — you can find more at Schwab if you want the gritty details.
And they can set their own beneficiary for any remaining funds in the account at the time of their own death, so the funds can pass along to the following generation tax-free.
The Long View: Roth IRAs for Young People
The contributions made to a Roth IRA as a teenager are enough to make you a multimillionaire by age 65.
If you (or your child) contribute $6,000 per year to a Roth IRA between the ages of 14 and 19, then never invest another cent, the account would contain nearly $3 million ($2,937,024.37) by the time you or they reach 65, assuming an historically average 10% annual return. And you wouldn’t owe a cent in taxes on your millions upon retiring.
That’s the incredible power of compounding, time, and starting young.
For that matter, you probably wouldn’t owe much in income taxes on the contributions in your teens, either. Single filers earning $9,875 or less in 2020 pay taxes at the 10% income tax rate.
Roth IRAs make ideal accounts for helping your children build wealth from an early age.
Roth IRA Restrictions
Not everyone can contribute to a Roth IRA and enjoy the tax benefits. Even those who qualify to contribute can’t simply dump as much money as they want into Roth IRAs.
As you plan your contributions, keep the following restrictions in mind.
To begin with, you can’t contribute more to an IRA than your reported earnings. If you report earnings of $3,000 for the year, you can’t contribute $4,000. This rule comes with one exception however: non-working spouses can still contribute to a spousal IRA if their spouse works.
The standard contribution limit to IRAs — both traditional and Roth — is $6,000 in 2020. Older adults age 50 and above can contribute an extra $1,000 on top of that as a “catch-up contribution.”
Note that this contribution limit applies as a combined limit for both traditional and Roth accounts. You can contribute to both IRA types in a single year, but the combined total can’t exceed $6,000 (or $7,000 at age 50 and above).
In 2020, single taxpayers can contribute the full amount to a Roth IRA if they earn a modified adjusted gross income (MAGI) up to $124,000. Above that, the ability to contribute starts phasing out, until disappearing entirely at a MAGI of $139,000.
Married couples filing jointly can contribute the full amount if they earn a MAGI up to $196,000. Between $196,000 and $206,000, the option phases out, and couples earning a MAGI over $206,000 can’t contribute at all.
Each spouse can contribute the full individual contribution amount, assuming their income falls below $196,000, for a combined contribution of $12,000 total for spouses under 50.
Early Withdrawal Penalties
Roth IRA holders can withdraw contributions any time, penalty-free. But what about earnings — the gains you’ve made from your investments inside the account?
Here, the IRS differentiates between “qualified” and “nonqualified” distributions. Qualified distributions are tax- and penalty-free, and require that your contributions have seasoned in your Roth IRA for at least five years. Beyond that five-year requirement, you must meet one of the following conditions for distributions to count as qualified:
- You are over age 59 ½.
- You have a permanent disability.
- You are using the money (up to $10,000) toward your first home.
- You are deceased and the Roth IRA is being distributed by your estate.
If you pull earnings out of your Roth IRA before the contribution has seasoned for five years, and without meeting at least one of the requirements above, the IRS slaps you with a tax bill on the withdrawn amount, plus a 10% penalty.
Roth Conversions and Backdoor Contributions
As a more advanced financial stunt, you can move money from a traditional IRA to a Roth IRA.
Imagine you contributed $50,000 to a traditional IRA, then came to realize that you’ll likely pay higher taxes in retirement than you do today. You decide you’d rather bite the bullet and pay income taxes on the contributions now, rather than letting them compound and have to pay taxes on withdrawals in retirement.
That point is worth reiterating: you owe income taxes on the amount you roll over and convert from your traditional to your Roth IRA. Those taxes could be significant, and could drive you into a higher tax bracket. But if timed well — such as in a year when you earned less than usual — it could save you taxes later.
One other related strategy worth mentioning is the backdoor Roth contribution. Technically, there’s no income limit for traditional IRA contributions — the income limit applies to what you can deduct from your taxes. So high earners can theoretically contribute money to a traditional IRA, not take the deduction, then do a Roth conversion to move the money into their Roth IRA despite earning more than the IRS allows.
But this gets complicated fast, with the IRS requiring you to calculate the share of earnings versus contributions in the account, along with a few other pitfalls such as state tax wrinkles. Speak with a financial advisor before attempting this at home.
For middle income earners, Roth IRAs offer a fantastic way to invest for retirement and lower their taxes later on. These accounts are flexible, allow returns to compound tax-free, and let you set aside wealth for your children both in their own Roth IRA and by bequesting your tax-free account to them.
Consider Roth IRAs an essential financial planning tool in your kit, and when in doubt, speak with a financial professional to get personal help and advice.
How do Roth IRAs fit into your retirement planning? What questions or concerns do you have about them?