Saving for Retirement – Benefits of a Roth IRA
One of the most common questions clients ask us is “How much money do I need to retire?” The answer varies greatly depending on how you have been saving for retirement up to this point. If you have only saved into a regular or high-yield savings account, then keeping up with inflation throughout your retirement will likely be difficult. If you have only saved into pre-tax retirement accounts like a traditional 401(k) and/or Individual Retirement Account (IRA), then you may experience what is known as a tax “time-bomb” during your retirement years. A better question to ask is “How much will I need and in what type of accounts should I be saving for retirement?” An often-underutilized type of account that can be very beneficial is a Roth IRA.
Many individuals seek the short-term benefits of getting a tax break today without considering long-term tax savings. Balancing out your retirement portfolio by contributing to a Roth IRA now is one way to minimize your taxes paid during retirement. When you contribute to a Roth IRA, your contributions are “post-tax”, meaning you’ve already paid taxes on your contribution funds. Any growth will accumulate tax free, but more importantly, qualified withdrawals will be tax free.
Why you should consider contributing to a Roth IRA:
Higher Taxes in Retirement
Considering taxes are likely to rise in the future, deciding to pay the tax now can save you money in your retirement years. This is especially true for young people who are at the beginning of their careers, and presumably, in a lower tax bracket than they will be later in life. However, even if you are in your 50’s, opening a Roth IRA will likely allow for 10-20 years of compound, tax-free growth before you would need to access the money. Roth IRA withdrawals, after age 59 ½ and after you’ve had the account for five years, are not considered taxable income.
Saving into a Roth IRA allows you to access your contributions without having to pay taxes or a penalty prior to age 59 ½ (taxes and penalties will apply if you withdraw the earnings). You can also make withdrawals before age 59 ½ for specific reasons without penalty, but taxes may apply depending on how long you’ve held the account. For example, you can take up to a $10,000 withdrawal for a first-time home purchase, pay for qualified education expenses, pay for qualified birth or adoption expenses, pay for unreimbursed medical expenses or health insurance if unemployed.
Required Minimum Distributions (RMDs)
Unlike owners of a Traditional IRA, original owners of a Roth IRA do not have to take annual minimum withdrawals beginning at age 72. However, when the original owner dies, the person who inherits the Roth IRA will be required to take distributions. These distributions will be tax free to the beneficiary if the original owner held the account for more than five years.
Flexibility Managing Taxable Income
Having multiple sources of retirement funds to draw from allows the retiree ultimate flexibility when planning for taxes and expenses that are affected by annual income. For instance, it is likely that more of your Social Security income will be taxed when you are pushed into higher income tax brackets. Also, Medicare premiums are based on your Modified Adjusted Gross Income (MAGI) so the higher your MAGI the higher your premiums (within Medicare premium brackets). Qualified withdrawals from your Roth IRA won’t figure into those income numbers allowing you to manage your taxable income and the impact on those expenses.
Active Retirement Plan Participants May Contribute to a Roth IRA
As long as you fall within certain income limits, you can directly contribute to a Roth IRA account even if you participate in your employer’s retirement plan. For 2021, maximum annual Roth IRA contributions are $6,000 (plus $1,000 catch-up for those over age 50). Contributions are limited or phased out if you earn more than $125,000 and file as Single (or $198,000 for Married Filing Jointly (MFJ)). Contributions are not allowed if you earn more than $140,000 as Single (or $208,000 for MFJ). These are the income limits that apply in 2021.
If you are not able to make direct Roth IRA contributions, there is the option of making “Backdoor” Roth IRA contributions. This is a two-step process where you must first make a nondeductible contribution into your Traditional IRA and then convert (or move) that contribution into your Roth IRA. Using a “Backdoor” Roth IRA is most tax efficient when you do not have a balance in your Traditional IRA and timing for the contributions and conversion is vital. This opportunity is best explored with your financial and tax advisor collectively.
Determining if and when, a Roth IRA contribution makes the most sense for you is part of the comprehensive financial planning that we provide to our clients. In our experience, diversifying account types in an individual’s portfolio of accounts increases the chances for a successful retirement.
The above discussion is based on current tax law and is for informational purposes only. Nothing herein should be considered individualized investment advice. C-J Advisory, Inc. is a registered investment adviser located in San Jose, CA. Registration of an investment adviser does not imply any level of skill or training and is not an endorsement of any regulatory agency. C-J Advisory does not provide tax or legal advice.