Roth IRAs can be an excellent wealth building tool if implemented and used properly. If you have any earned income and have the discipline to save even a little bit, a Roth IRA can be an ideal investment vehicle for you. Here are 5 reasons you should own a Roth IRA.
1. Roth IRAs have fantastic tax benefits, for now…
Roth IRAs are a tax-deferred retirement savings vehicles that if used properly can provide you with tax-free investment earnings after age 59 ½.1 This is their primary benefit over other pre-tax retirement savings vehicles such as Traditional IRAs, 401(k)s, 403(b)s, etc. which are also tax-deferred but fully taxable when funds are withdrawn.
The tax-deferred component gives you more compounding power since you don’t have to pay taxes each year on the earnings, and the tax-free component when the money is withdrawn is well…tax-free!
The money that you put into a Roth IRA is after-tax money. Simply put, you fund a Roth IRA with money that is already in your bank account − which was already taxed when you earned it. Therefore, that money will always come back out tax-free.
Another major reason people choose a Roth IRA as opposed to pre-tax investment vehicles is that they think they will be in the same or a higher tax bracket in retirement. This can be because you work throughout retirement (some of us actually love what we do), operate/have someone else operate your business, or produce a good amount of income producing assets over your lifetime.
We also don’t know what tax rates will look like when we reach our respective retirement ages, they could be twice as high! or even lower. However, when you take funds from your Roth IRA(s) in retirement you will not have to worry about tax implications when doing so. Freedom!
This leaves us with one simple question: Will Roth IRAs always be available? Who knows, hopefully they are here for the long run, but they may not be. Start one while you can.
2. You can take back out what you put in, whenever you want.
As mentioned previously, the dollars you contribute to your Roth IRA have already been taxed. Therefore, there is no penalty or taxes due if you take that money back out. Only the earnings are subject to taxes and a potential 10% penalty – see my article here on other Roth IRA rules.
If you already have earnings in your Roth, you can make a withdrawal of just your contributions and leave the earnings in it to continue growing and avoid taxes and penalty.
This gives you a ton of flexibility when compared to other retirement savings vehicles. You have liquidity and the option to go get that money for any reason such as emergencies (although you should have an emergency fund already)!
3. Grandma and Grandpa can set your kids (or you) up with a nice chunk for retirement!
You can have a Roth at any age, as long as you:
- Have earned income (income from W-2 or net self-employment income).
- Aren’t ineligible to make an initial contribution to open a Roth IRA due to the income limitations set forth by the IRS. If your Modified Adjusted Gross Income is over the following amounts, you cannot contribute (although you still may be able to start a Roth IRA using an alternate method; discussed in number 3):
$137,000 | If filing Single, Head of Household, or Married Filing Separately and did not live with your spouse during the year.
$203,000 | If filing Married Filing Jointly (MFJ), or are a Qualifying Widower.
$10,000 or more | If filing Married Filing Separately and lived with your spouse at all during the year.
These are the limits that prevent you from making any amount of contribution; You can’t even contribute $1 to a Roth. Depending on income, you may still only be able to make partial or phased-out contributions. You also cannot contribute over the annual contribution limits for Roth IRAs which are currently $6,000 if under age 50, and $7,000 if over age 50 for 2019. These amounts typically adjust with inflation.
One more thing to note is that the IRS does not care who makes the contribution to the Roth account. They just want to know if the account owner had earned income for the year and are under the income limits. This means grandma and grandpa, or anyone else can gift you or your child money to contribute to a Roth IRA!
Therefore one strategy that can be used by families is that if a child of any age (Custodial Roth IRA if under age 18, or depending on state rules) meets the above criteria, other family members can gift them money to contribute to their Roth IRA for Birthdays or Holidays ̶ as long as the amount contributed isn’t greater than the Roth owner’s earned income.
Let’s see this in action:
You have a 16 year-old child that you employ in your business ̶ see my article here about hiring your children to save taxes to maximize on this idea ̶ and they have earned income of $5,000 for the year. Grandma can gift any amount up to $5,000 that your child can then turn around and contribute to their Roth IRA.
Or let’s say grandma sends your child $200 for their birthday every year for the next 10 years and your child decides that it would be a smart idea to put the money away in their Roth each year…
Let's say your child invested each annual gift of $200 for 10 years and then stopped contributing altogether (g-ma and g-pa will probably cut them off at some point). Then they held onto that Roth IRA for the next 40 years (50 total) and averaged an 8% return, that account would be worth roughly $63,000 when they are age 66! TAX-FREE!2 If the process is repeated with other potential gifts, you can see how the effects can be substantial.
4. I make too much money so I can’t have a Roth IRA, WRONG!
People have told me numerous times, “I make too much money, or me and my spouse make too much money, I can’t get a Roth IRA.” I’m still not sure whether these people were bragging about their income? Or complaining that they can’t have a Roth and give up. Either way they are wrong. If you make “too much”, you should want a Roth even more.
So how can you still open a Roth IRA if you surpass the income limitations?
Door Number 1: Roth Conversions. Have a Traditional IRA or balance in your pre-tax 401(k) account? You can convert a pre-tax IRA to a Roth IRA no matter what your income is. This means you pay the taxes owed on the entire amount converted in the year you convert it. You can also convert pre-tax 401(k) funds to a Roth 401(k) account in most 401(k) plans. This is a taxable event so again, please consult with your advisors.
Door Number 2: Contribute to a Roth 401(k). If your employer offers a 401(k), you likely have the ability to make Roth 401(k) contributions. Yes most 401(k)s have Roth contribution options! The maximum amount you can contribute for 2019 is $19,000 if under age 50 and $25,000 if over age 50. You may be able to contribute more by using non-deductible 401(k) contributions, then converting those to the Roth in the 401(k), if your plan allows for it.
Again, your income does not matter. Note that if you receive an employer match or profit sharing, those employer contributions will not be Roth (after-tax) contributions, they will always be pre-tax.
Do you own a business with just you, or you and your spouse? You can go open what we call a Solo(k)! − 401(k) for businesses with one owner/employee although a spouse can be added. These Solo(k)s also give you the ability to have Roth contributions up to the previously stated limits.
Door Number 3: The Back-Door Roth IRA. Make a non-deductible IRA contribution and then convert it to a Roth IRA. This can be done no matter what income level you are at! The net tax result from this is $0, and you now have a Roth IRA, yay! There are a few potential caveats to this so please contact your professional advisor before doing so.
5. Roth IRAs do not have required minimum distributions or RMD.
Required minimum distributions are applicable to most retirement accounts which basically says that upon obtaining age 70 ½, you must start taking a minimum amount out of your account. That minimum is based on your account value as of the year prior and a mortality factor provided by the IRS. This is because in pre-tax accounts like IRAs or 401(k)s, you have essentially been “sheltering” that money from taxation for so many years, that now they want their tax-dollars!
Roth IRAs do not have RMDs! You can keep that money in there for as long as you’d like (unless you pass and the Roth is inherited by someone else). Roth 401(k) accounts do have RMDs, however you can avoid them by rolling it to a Roth IRA – see my article here on how you can use this to your advantage.
The Bottom Line
Roth accounts can be advantageous to most people. There are a ton of unique planning techniques that can be used, not all of which were mentioned here. There are also other rules that may apply to some of these strategies, so it is important to always consult with a professional prior to making any moves.
One last important recommendation would be to start or open a Roth IRA as soon as you can using any of the previously discussed methods, or by simply making a contribution. This will open you up to more opportunities down the road. See our blog Plan-It for more ideas to build wealth using Roth IRAs, and stay tuned for more videos on how to build wealth creatively.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
1 Roth distributions from earnings are tax-free if your initial contribution to the account was made at least five years ago and you meet one of the following conditions:
- you’re age 59½
- you’re disabled
- you’re purchasing a first home (up to $10,000 lifetime maximum)
Distributions from earnings are not subject to the 10% penalty if you qualify for an IRS exception — please consult with your tax advisor for details. Distributions from a conversion amount must satisfy a five-year investment period to avoid the 10% penalty. This pertains only to the conversion amount that was treated as income for tax purposes.
2 The hypothetical examples are for illustration purposes only and are not intended to be representative of actual results or any specific investment, which will fluctuate in value. The determinations made by these examples are and not intended to be reflective of results you can expect to achieve, and no taxes or fees/expenses are included in the calculations, which would reduce the figures shown. Please keep in mind that it is possible to lose money by investing and actual results will vary.
The information provided is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The strategies mentioned here may not be suitable for everyone. Each investor needs to review strategies for his or her own particular situation before making any financial or investment decisions.
Waddell & Reed does not provide legal or tax advice. Please consult a professional prior to making financial decisions.
Information is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. (09/19)