Among the resources available to enable investors to achieve both their pre-retirement and retirement goals, the Roth IRA is a particularly valuable “arrow in your quiver.”
As a savings vehicle, a Roth IRA is available to anyone, regardless of age, who has earned income up to certain annual limits (a phaseout range of $122,000 – $137,000 of Modified Adjusted Gross Income for single filers and $193,000 – $203,000 for joint filers in 2019). Currently, contributions up to the lesser of earned income or $6,000 ($7,000 for those age 50 or over) are permissible. Those contributions, made with after tax monies, are not a deductible item on your tax return. They can, however, be withdrawn tax free at any time.
Whether the earnings on those contributions can also be withdrawn free of taxes and penalties will depend upon your age, the length of time the account has been open, and how you plan to spend the earnings that you withdraw. Where a Roth IRA has been open for less than five years, withdrawn earnings will be subject to taxes. (The five year clock starts on January 1st of the tax year for which your first Roth IRA contribution was made.) In addition, a 10% penalty may be applied if you are under age 59 ½ when making those withdrawals, subject to certain exceptions. Uses of the Roth IRA to fund life and retirement goals, while navigating those rules, are illustrated through the purposes and strategies outlined below.
Though primarily a retirement resource, Roth IRAs can be used to fund other, pre-retirement goals where penalties are avoided even if earnings withdrawals are made prior to age 59 ½:
1. College Costs: You can use your Roth IRA to fund qualified higher education expenses for yourself, your spouse, your children, or grandchildren, including tuition, fees, books, supplies, and equipment, as well as room and board (if the student is enrolled at least half time). Other college saving vehicles, such as 529 plans, should likely be considered, but for those concerned about saving for both retirement and college, the flexibility of the Roth IRA can be appealing.
2. Home Purchase: You can withdraw up to $10,000 ($20,000 for joint filers) towards a first-time primary residence purchase for yourself, your parents, your children, or grandchildren. The IRS definition of first-time purchaser is fairly broad.
3. Medical Expenses: Roth IRA earnings can be drawn penalty free to pay any unreimbursed medical expenses that exceed 10% of your adjusted gross income (assuming you itemize deductions).
4. Health Insurance: To cover premiums during periods of unemployment.
While a possible supplement to fund the needs mentioned above, the primary aim of Roth IRAs is, of course, retirement funding:
5. Accumulation: Those eligible should make the maximum contribution if possible. Where cash flow allows, this might involve an employee maximizing 401k contributions and taking advantage of any company match, and then in addition fully funding a Roth IRA. Notably, Roth IRAs for both spouses can be funded even if only one is working, assuming the income eligibility criteria are met. Also, Roth IRA contributions need not come directly from a paycheck, but can come from any source (i.e. savings or brokerage account, etc.)
6. Back Door: If your income level is too high to contribute directly to a Roth IRA, you may still be able to convert monies to Roth status at little to no tax cost. This strategy, known as a “Back Door Roth,” involves making a non-deductible contribution to a traditional (pre-tax) IRA, and then converting those monies to a Roth account after a reasonable time. This is best employed by those who have no previous IRA savings.
7. Conversion: In some cases, retirees have a range of time within which they no longer receive wages but have not yet begun Social Security distributions or RMDs from qualified accounts, leaving them with lower taxable income. In this window, engaging in Roth conversions incrementally year by year, may be advisable. Conversions, where pre-tax monies are moved over to Roth status, are a taxable event. However, engaging them when your tax rates are lower, and setting the stage for future tax-free withdrawals when your tax rates may be higher, can be advantageous.
8. Distribution: Original Roth IRA owners are not subject to Required Minimum Distributions (RMDs) but may be able to rely on tax and penalty free Roth IRA withdrawals in retirement. This means their cash flow needs are being met while their taxable income is kept low. Additional benefits that may flow from this reduced level of taxable income could include lower Medicare premiums, reduced taxation of Social Security distributions, and possibly a 0% capital gains tax rate.
With their long-term tax savings features, Roth IRAs can be valuable even beyond retirement, in the context of what we might call legacy planning:
9. Next Gen: Where a child or grandchild has some level of earned income (i.e. a summer job, for example), employees or retirees with sufficient resources might consider helping to fund a Roth IRA for them. This is a great vehicle to teach the habit of saving and the benefits of tax-free compounding over a long-term time horizon.
10. Inheritance: Using a Roth IRA to pass assets to the next generation (a child or non-spouse beneficiary where spouse is already deceased, for example) can be beneficial in providing that beneficiary a source of tax-free withdrawals over the course of their potentially lengthy lifetime. While an inherited Roth IRA is subject to Required Minimum Distributions (RMDs), those distributions are not taxable if the original account owner had held the account for five years or more. Designation of a beneficiary on the Roth account also enables those assets to avoid the probate process.
The discussion above is not meant to be exhaustive in terms of Roth IRA rules or exceptions, and the appropriateness of the various uses and strategies mentioned will vary based upon the goals, resources, and circumstances of each individual. Hopefully, however, they reflect the ways in which Roth IRAs can assist in funding assorted life goals before, during, and after retirement in the context of a tax efficient financial plan. To see how they might fit within your own plan, please consult your Wealth Manager.