Things You Must Know About Roth
Accounts
1.
Tax-free income is a dream of every taxpayer. And if you save in a Roth
account, it's a reality. Roths are the youngsters of the retirement
savings world. The Roth IRA, named after the late Delaware Sen. William
Roth, became a savings option in 1998, followed by the Roth 401(k) in
2006. Creating a tax-free stream of income is a powerful retirement
tool.
These accounts offer big benefits, but the rules for Roths can
be complex. Here are ten things you must know about adding a Roth to
your nest egg.
2. You Pay Uncle Sam Now Instead of Later
Roths turn traditional IRA and 401(k) rules on their head. Rather than
getting a tax break for money when it goes into the account and paying
tax on all distributions,
with a Roth, you save after-tax dollars and
get tax-free withdrawals in retirement.
By accepting the tax
breaks for traditional accounts, you accept the government as your
partner. If you're in the 25% tax bracket, for example, 25% of all
earnings will effectively belong to the IRS to be collected when you
withdraw the money. With a Roth, 100% of all future earnings are yours.
The Roth strategy of paying taxes sooner rather than later will pay
off particularly well if you're in a higher tax bracket when you
withdraw the money than when you passed up the tax break offered by the
traditional account. If you're in a lower tax bracket, though, the Roth
advantage will be undermined.
3.
There Are Limits to Contributing to a Roth IRA
To be able to contribute to a Roth, you must have earned income.
And unlike traditional IRAs, if you're still working after age
70 1/2, you can keep contributing.
In
2013 and
2014, you can stash up to $5,500 in a Roth IRA and an
extra $1,000 if you're 50 or older.
But higher-income taxpayers are barred from contributing to a
Roth IRA. For 2013, the ability to contribute to a Roth phases
out if your adjusted gross income is between $178,000 and
$188,000 for joint filers and between $112,000 and $127,000 for
single filers. Those thresholds go up for 2014: $181,000 to
$191,000 for joint filers and $114,000 to $129,000 for single
filers.
You can make a 2013 Roth IRA contribution as late as April
15, 2014. You can contribute to both Roth and traditional IRAs,
but the total cannot exceed the annual limit.
4.
Your Company May Offer a Roth Option
Many companies have added a
Roth option to their 401(k) plans. After-tax money goes into the
Roth, so you won't see the immediate tax savings you get from
contributing pretax money to a traditional plan. But your money will
grow tax-free. (Any employer match will go into a traditional 401(k)
account.)
For 2013 and 2014, you can stash up to $17,500 a
year, plus an extra $5,500 a year if you're 50 or older, into a
401(k). Contributions must be made by December 31 to count for
the current tax year, and the limit applies to the total of your
traditional and Roth 401(k) contributions. A Roth 401(k) is a good
option if your earnings are too high to contribute to a Roth IRA.
5.You Can Do a Roth Conversion
Another route to tax-free earnings inside a Roth is to convert
traditional IRA money to a Roth. In the year you convert, you must
pay tax on the full amount shifted into the Roth. That's the price
you pay to buy tax freedom for future earnings. (If you have made
nondeductible contributions to your traditional IRA, a portion of
your conversion will be tax-free.)
If you expect your tax rate
to be the same or higher in the future, converting could make sense;
if you expect your future tax rate to be lower, it might not.
You'll want to pay the tax owed on a conversion with money
outside of the IRA. Drawing money from the IRA to pay the tax will
result in an additional tax bill, and a penalty if you're under age
59 1/2.
6.
A Conversion Could Trigger Other Tax Events
Look at the big picture if you plan a conversion. The added
taxable income could boost you into a higher tax bracket. A
big jump in income could trigger other taxes, too, such as
the
new 3.8% surtax on net investment income. For Medicare
beneficiaries, a rise in adjusted gross income could result
in
premium surcharges for Part B and Part D.
A series of
small conversions over several years could keep the tax bill
in check. For instance, you may want to convert just
enough to take you to the top of your current tax bracket.
7.
You Must Pass the Tests for Tax-Free Earnings
Because there's no tax deduction for Roth contributions, you can retrieve
that money at any time free of taxes and penalties, regardless of age.
But
for earnings to be tax- and penalty-free, you have to pass a couple of
tests. First, you must be 59 1/2 or older. You will get hit with a
10% early-withdrawal penalty and taxes if you take out earnings before you
hit age 59 1/2. And you must have had one Roth open for at least five
years. If you are 58 and opening your first Roth IRA in 2013, you can
tap earnings penalty-free at age 59 1/2, but you won't be able to tap
earnings tax-free until 2018.
There's a different rule for conversions. Read on.
8.There Are Two Five-Year Rules
If you make a conversion,
you must wait five years or until you reach age
59 1/2, whichever comes first, before you can withdraw the converted amount
free of the 10% penalty. Each conversion has its own five-year holding
period. So if a young account owner does one conversion in 2013 and a second
conversion in 2014, the amount from the first conversion can be withdrawn
penalty-free starting in 2018 and the amount from the second starting in
2019.
Earnings on a converted amount can be withdrawn tax- and
penalty-free after the owner reaches age 59 1/2, as long as he or she has
had any Roth IRA opened at least five years.
9. There's an Order to Withdrawals
The rules for determining the source of money coming out of a Roth work
in the taxpayer's favor. The first money out is considered contributed
amounts, so it's tax- and penalty-free. Once contributions are depleted, you
dip into converted amounts (if any). This money is tax- and penalty-free for
owners 59 1/2 and older or younger ones who have had the converted amount in
a Roth for more than five years. Only after you have cashed out all
converted amounts do you get to the earnings. Once the account owner is 59
1/2 and has had one Roth for at least five years, earnings, too, can be
withdrawn tax- and penalty-free.
The ability to tap money in a Roth IRA
without penalty before age 59 1/2 allows for flexibility to use the Roth IRA
for other purposes. For example, the account could be used as a fallback for
college savings.
Once you reach retirement, having a pot of tax-free income to draw upon
may allow you to lower your tax bill. Roth money doesn't count in the
calculation for taxing Social Security benefits, for example, or in the
calculation for the new tax on investment income.
10.
Things You Must Know About Roth Accounts
You Can Take a Mulligan
Roth IRA conversions come with an escape hatch. If you converted $50,000 but
the Roth is now worth $35,000, you would still owe tax on the $50,000.
Undoing the conversion—known as a recharacterization—wipes away the tax
bill. Recharacterizing can also pay off if you can't afford the tax bill
or the conversion unexpectedly pushes you into a higher tax bracket.
You
have until October 15 of the following year
to undo a conversion. So a 2013 Roth IRA conversion can be reversed up
until October 15, 2014.
But note: While you can now convert a traditional 401(k) to a Roth 401(k)
within a company plan,
an in-plan conversion cannot be reversed.
11. A Roth Can Benefit Heirs
Unlike traditional IRAs—which you must begin to tap at age 70 1/2—Roth IRAs
have no minimum distribution requirements for the original owner. So, if you
don't need the money, it can grow in the tax shelter until your death. If
your spouse inherits the account, he or she never has to make withdrawals,
either.
If the Roth IRA passes to a nonspouse heir, the rules change. They
are required to take minimum distributions starting the year following the
death of the original owner, or empty the account within five years of the
account owner's death. Distributions, though, will still be tax-free and can
be
stretched over the beneficiary's life expectancy. A young child or
grandchild who inherits a Roth has the potential for decades of tax-free
growth.
Wealthy taxpayers may find another estate-planning advantage to a Roth
conversion. The taxes paid on a Roth conversion will be removed from their
taxable estate.
6.