Financial Planning 101 - What You Need to Know About Roth Accounts
It has been a while since my last blog post on traditional IRA accounts. There have been quite a few changes in the world since then and I have put a focus on trying to deal with issues related to COVID-19 and its fallout. As a result, the blog activity was put on the back burner. While COVID continues to dominate our national discussion and there is much uncertainty on how and when we can get back to a sense of normalcy, there are planning opportunities that have been created as a result, and those need to be discussed.
One of the biggest financial planning opportunities that has been created is the increased potential benefit of Roth conversions. Before getting into conversions, though, let’s understand what a Roth account is first. To do that we’ll discuss how Roth accounts are different from other accounts and the pros/cons of this type of account.
Remember that the 401k and IRA account contributions are pre-tax, meaning that the contributions are removed from your income before they figure out the income tax calculation. On the back end though all distributions, including both contributions and earnings, are all fully taxable. With a Roth plan it is just the opposite. Contributions are post-tax but all distributions, including both contributions and earnings, are tax-free.
Here is an example of how this works using simple math (actual tax rates and amounts would be different due to tiered tax rates). Say your salary is $100,000 and you want to contribute 10% ($10,000 in this case) to a Roth and are in a 22% tax bracket. Your $100,000 is taxed at 22%, or $22,000, leaving you with an after tax amount of $78,000. The $10,000 Roth contribution then comes out of the $78,000 leaving you with a net of $68,000.
In comparison, a 401k would take the $10,000 contribution from the $100,000 leaving $90,000 to be taxed. At 22% this would be $19,800 leaving a net of $70,200. So while the 401k might leave more money in your pocket right away the Roth makes up the difference when you withdraw the funds by not paying taxes at that time.
Here’s how it works on the back end. Let’s say in retirement you withdraw $50,000 and are in the 12% tax bracket. If you withdraw the funds from an IRA or 401k you would have to pay 12% in taxes on that $50,000, leaving you with a net of $44,000. If instead the funds were a qualified withdrawal from a Roth IRA or Roth 401k the entire $50,000 would be tax-free leaving a net of $50,000.
One key thing to note with Roth accounts is that your contributions can always be withdrawn tax-free as you have already paid income taxes on the money used for contributions, but the earnings need to meet certain criteria to be withdrawn tax-free. The Roth account must have been open for at least five years and the individual must be at least age 59 ½. There are exceptions to this which include distributions for the following: certain health insurance and medical expenses; higher education expenses, up to $10,000 towards a first home or to meet an IRS levy.
Any distributions not meeting the criteria listed above or for one of the exceptions incurs the same penalty as an early distribution from an IRA/401k which is a 10% penalty in addition to the distribution being considered taxable income.
Important things to know
If your employer offers a 401k plan with a Roth option you can split your contributions between the traditional 401k and the Roth however you choose. One thing to note is that your employer match will be placed in the traditional 401k account. So if you are looking for a specific split between the two types of accounts you will want to take the match into consideration as well.
Contribution limits are the same with a Roth 401k as they are a traditional 401k, $19,500 for 2020 plus an additional $6,500 catch up if over the age of 50. This contribution limit can be split between the traditional and Roth accounts. They are also the same for a Roth IRA and a traditional IRA which is $6,000 plus an additional $1,000 if over age 50.
There are income limits for being able to contribute to a Roth IRA account. Phaseout ranges are $0-$10,000 if married filing separately, $196,000-$206,000 if married filing jointly and $124,000-$139,000 for everyone else. There are no income limits for contributing to a Roth 401k.
When does a Roth make sense compared to other investments?
The decision to use a Roth account compared to a traditional IRA/401k account really comes down to current vs. future tax rates. Ideally what you want to do is use whatever type of account today that will help you avoid the higher tax rate you will experience in working years compared to retirement.
If your income is lower, and are therefore in a lower tax bracket, it makes sense to pay the tax now on your income, invest in a Roth, and then enjoy the tax free growth. This is usually the case for people earlier in their career or maybe in a down economic cycle like we are in now. For example, a young worker is making $50,000 and is in a 15% tax bracket. They anticipate growth in their career and earnings, which should hopefully result in a nice sized nest egg for retirement. As a result of their various savings and income sources they may find themselves in a 24% tax bracket in retirement. In this case, it would be smart to be in a Roth, pay the 15% taxes now, and then enjoy tax free distributions that would avoid the 24%.
Likewise, the traditional IRA/401k makes more sense when your income is higher. Someone in their peak earning years might be making $350,000 per year which puts them in a 32% tax bracket and upon retirement is anticipating $150,000 of income from various retirement sources which places them in the 22% bracket. In this case, it makes sense to avoid paying the 34% today and, instead pay the 22% in retirement.
Finally, a Roth makes sense in general as a future tax rate hedge. While we don’t know what future rates will be we do know that the current tax rates which were introduced in 2016 are set to expire in 2026. Those expiring lower rates combined with a concern that our growing debt will require higher future tax rates might make all current tax rates attractive to what may await us in the future.
This wraps up the basics of Roth accounts. I hope this helps explain the basics of the plan to you. If you have questions on whether a Roth is right for you reach out to us at email@example.com. I’ll try to get back on a regular schedule with the blog. Look for the next installment on Roth conversions.
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