Year-end: a time for looking back, as well as looking forward. As it pertains to saving for retirement, year-end may be a good time to review one’s progress in saving for the future, while also considering strategies for saving more. For example, starting the new year with an increase in one’s 401(k) plan contributions is a simple yet effective strategy for building additional wealth, as is making a tax deductible contribution to a traditional IRA.
While each of these strategies can help build wealth for the future, while lowering one’s current taxable income, the contributions and earnings from these types of tax-deferred vehicles will eventually be taxable when the funds are withdrawn. For those who’d like the opportunity to save for the future while benefiting from tax free distributions in their later years, however, a Roth IRA may be worth a look.
Born from the Taxpayers Relief Act of 1997, and named for former Senator William Roth of Delaware, a chief architect and proponent of this retirement savings tool, Roth IRAs offer individuals the opportunity to make IRA contributions with after tax dollars, as opposed to pre-tax dollars which is the norm with traditional IRAs. Over the life of the investment, earnings grow on a tax-free basis, and when distributions are withdrawn from the accounts, they’re completely tax free, provided the rules are followed.
Understanding the Mechanics
While Roth IRAs are available to individuals of any age who have earned income, there are eligibility limits based on income. For tax year 2016 and 2017, individuals can contribute up to $5,500 with a $1,000 catch-up contribution available to those age 50 or older.1 In 2016, contribution phase-outs for single tax filers begins with a modified adjusted gross income (MAGI) of $117,000, and at a MAGI of $132,000, individuals are ineligible to contribute.2 For married filers, phase-out begins at $184,000 with ineligibility at $194,000.3
For 2017, the IRS has raised the income threshold at which phase–out will begin such that for single filers, phase-out will begin at $118,000 with ineligibility at $133,000.4 For married filers, phase-out will start at $186,000 with ineligibility at $196,000.5
While individuals can contribute up to $5,500 for the year, contributions cannot exceed the amount of income that was earned. For example, if an individual earned only $2,000 in 2016, $2,000 is the maximum amount that could be contributed for the year. Similarly, both working and non-working spouses are eligible to make a $5,500 contribution for the year provided the working spouse has enough earned income to cover both contributions.6
And how about age restrictions or required minimum distributions? Unlike traditional IRAs, there aren’t any. While individuals over age 70½ are no longer eligible to make contributions to a traditional IRA, anyone, regardless of age, can make a contribution to a Roth. Furthermore, distributions from the account are never required. For those looking to leave money to their heirs, these features allow them to continue saving for their beneficiaries in their later years, with the money continuing to grow indefinitely. Upon the passing of the account owner, a spouse who has been named as beneficiary can assume the IRA as his or her own, with no distributions required. Non-spousal beneficiaries, on the other hand, are required to take minimum distributions each year from the inherited IRA, but those distributions are income tax free.7 Furthermore, if managed appropriately, the beneficiary can potentially “stretch” the IRA, thereby providing him or herself with a source of lifetime income.
Given that Roth contributions are made with after tax dollars, account owners are able to withdraw the contributions at any time, free of taxes or penalties. Earnings, however, are typically available for withdrawal tax and penalty free only after the account has been held for at least five years, and the owner has reached age 59½.
While the five-year, 59½ rule is the norm for withdrawing earnings tax and penalty free, the IRS does allow an exception in the case of death or disability of the account owner. As well, withdrawals of up to $10,000 of earnings are permitted, tax and penalty free, as long as the account has been held for five years, and the owner is using the funds to purchase a first home, or helping children or grandchildren with a similar purchase.8 Lastly, withdrawals of earnings may be made for higher education expenses for the owner, a spouse, children or grandchildren. Keep in mind, however, that if the withdrawal occurs before the owner reaches age 59½, or before the account has been held for five years, the earnings will be taxable, but free of early withdrawal penalties.9
Roth IRAs: Who May Benefit?
While one could make the case that almost anyone could benefit from a long-term investment program that offers the opportunity for tax free growth over time, Roth IRAs may be particularly appealing to younger investors who may still be in the early stages of their careers. Given that many in this group have a long investment time horizon, and may be in a lower tax bracket, it may make sense for them to forgo the tax deductibility of a traditional IRA contribution today in exchange for tax-free distributions from a Roth in their later years, when they may be in a higher income tax bracket.
In addition to younger savers, a Roth may make sense for those seeking to minimize taxable income in retirement, as well as individuals who, as we discussed previously, are seeking to provide for their beneficiaries while minimizing the beneficiaries’ tax burden.
Additionally, the owner of a traditional IRA may benefit from a Roth conversion if he or she expects a reduction in earnings in a given year. Why? When converting from a traditional IRA to a Roth IRA, the converted proceeds from the traditional IRA are treated as taxable income. If an individual anticipates a temporary decline in earnings, a conversion may make sense at that time given that the person may be in a lower tax bracket, and will therefore owe less in taxes on the converted proceeds. Similarly, those who believe that higher income taxes are in store for the future may also wish to convert. By converting now, these individuals are potentially avoiding the higher rates, and potentially bigger tax bite, that may apply to their distributions in the future.
Have questions? We’re here to help.
Obviously, there’s a lot to consider when choosing a strategy for saving for retirement. If you’re planning to contribute to an IRA, you’ll first need to decide which may be right for you; a traditional or a Roth. Additionally, over time, you may have questions regarding distributions, how to maximize tax efficiency, or if a Roth conversion may be right for you.
As always, please contact us with questions, or if we can help you craft a retirement strategy designed to help you achieve your unique goals and objectives.
2, 3, 4, 5 Ibid.
Content written by Symmetry Partners, LLC. Our firm utilizes Symmetry Partners, LLC for investment management services. Symmetry Partners, LLC, is an investment adviser registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. All data is from sources believed to be reliable, but cannot be guaranteed or warranted. No current or prospective client should assume that future performance of any specific investment, investment strategy, product or non-investment related content made reference to directly or indirectly in this article will be profitable. As with any investment strategy, there is a possibility of profitability as well as loss. Please note that you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from Symmetry Partners or your advisor.
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