A Roth IRA is an important part of a retirement plan portfolio and deserve a close look from those wanting to make the most of their financial planning. This powerful retirement planning tool was first introduced as part of the Taxpayer Relief Act of 1997 by then Senator William Roth, Jr. from Delaware. Prior to its introduction most retirement accounts were simply tax deferred savings vehicles.
Until 1997, retirement accounts like 401(k), 403(b), and traditional IRAs all operated on a tax deferred basis. Under this tax structure, retirement savers receive a reduction in taxable income in the year of the contribution in exchange for paying tax on withdrawals at a future date in retirement. With the introduction of the Roth IRA, retirement savers could now save for retirement in an account that would allow future withdrawals to be tax free.
Here are five things you must know about the Roth IRA:
- Tax free: While most retirement accounts require withdrawals in retirement to be taxed as ordinary income, Roth IRAs allows withdrawals to be considered tax free. A more complete description of the difference between tax deferred and tax free can be found here. Because there is no upfront reduction in taxable income in the year of the contribution, Roth IRAs are funded with after tax dollars. Once these funds are added to the Roth IRA, they grow without annual tax on dividends, interest, or capital gains. So long as the future withdrawals are “qualified distributions,” they are considered tax free.
- Annual contribution limit: The annual contribution limit for a Roth IRA in 2017 is $5,500 per person ($6,500 if age 50 or older). It is important to note this is a combined limit with traditional IRAs. For example, an individual can’t contribute $5,500 in a Roth IRA and do an additional $5,500 in a traditional IRA. Also, since it is a per person limit, each spouse can contribute the $5,500 for a total of $11,000 ($13,000 if age 50 or older). The amount you can contribute is limited to your taxable compensation. For example, if your taxable compensation for the year was $4,000, that would be the maximum you could contribute.
- Income limits: There are also limits on contributing to a Roth IRA based on income. This is where some people end up missing out and why procrastination can really hit you where it hurts. If your income is over a certain amount, your Roth IRA contribution begins to phase out. More information on the income limits depending on tax filing status is found at the IRS website. The main take away here is that you need to take advantage of a Roth IRA while you can. Salaries and income tend to increase over time. By the time you get around to funding a Roth IRA, you may come to find that you’re no longer eligible based on income. If that happens you will have missed an opportunity to accumulate a sizable portion of your retirement funds in a special tax free account.
- No RMDs: Most retirement accounts have required minimum distributions (RMDs) upon reaching age 70 1/2. If you have funds in a 401(k), 403(b), or traditional IRA, the IRS requires that you begin taking minimum withdrawals from the account. These RMDs are based on the IRS life expectancy tables and the amounts are included in your taxable income. Another great aspect of Roth IRAs is their exemption from this RMD rule while the account owner is alive. That means you can keep your money invested longer and continue to enjoy its special tax advantages.
- Inheriting a Roth IRA: If you inherit a Roth IRA, some of the RMD rules will come into play. If you inherit a Roth IRA from your spouse and you were the sole beneficiary, the surviving spouse can treat the Roth IRA as their own and are not subject to RMDs. If you inherit a Roth IRA from someone other than your spouse, you cannot treat the Roth IRA as your own and are now subject to RMDs. This prevents funds remaining in a tax free account indefinitely.
Roth IRAs are powerful retirement planning tools and they should not be ignored. This article is not intended to say Roth IRAs are better than tax deferred accounts like 401(k), 403(b), and traditional IRAs. It is not about which one is better as much as it is about understanding the differences. Roth IRAs are an important part of the retirement planning process. If you’re looking to take your retirement portfolio to the next level, give them a look. You’ll be glad you did.