20 years ago, Congress passed the Taxpayer Relief Act, bringing the Roth IRA into existence. Since that time, it has grown in popularity, and become an important feature in retirement planning.
At the ten-year mark, in 2007, the number grew to 3.3 trillion dollars among 50 million investors. Faster growth in the popularity of Roth accounts occurred between 2010 and 2013, with the number of accounts increasing by 51.6%, according to the EBRI (Employee Benefit Research Institute). This growth was attributed to an increase in Roth conversions from traditional IRA accounts or 401K rollovers.
How Does a Roth Account Differ from a Traditional IRA?
Roth and Traditional IRAs have many similarities along with a few important differences to understand before considering a Roth conversion.
Tax treatment. One of the key differences is the tax treatment of contributions. A Traditional IRA receives an immediate tax benefit, by lowering taxable income. Roth accounts use after tax dollars with no upfront benefit.
Roth accounts gain the advantage with a back-end benefit of tax-free withdrawals. With a Traditional account, money grows tax-deferred, and you pay income taxes at the ordinary income rate at the time of withdrawal.
- Early withdrawal penalties. Withdrawing funds from a Roth IRA considers both contributions and account growth or earnings. You can access contributions without taxation before 59 ½ without penalty. Earnings removed before this time, which do not meet a qualified exception, have a 10% penalty attached. A Traditional account imposes a 10% penalty on all withdrawals not meeting a qualified exception, before age 59 ½. All distribution amounts are typically subject to taxes at the earned income rate.
- The five-year rule. One unique feature of a Roth account is the requirement to wait five years before withdrawing funds, regardless of age. Removing money from the account prior to reaching the five-year milestone leads to taxation of earnings, along with a potential 10% penalty if you are under 59 1/2.
- Withdrawal exceptions. Roth accounts have a more limited list of exceptions than Traditional accounts. Withdrawals to buy your first home (up to $10,000), qualified educational expenses, some unreimbursed medical bills, and health insurance premiums while unemployed are the primary exclusions which waive the early withdrawal penalty.
- Income limits. Roth IRA accounts limit contributions based on tax filing status and household income. Single filers earning less than $133,000 qualify to contribute to a Roth account with reduced contributions beginning at $118,000. Married filers who file jointly have a maximum income of $196,000 with the phase out beginning at $186,000. Income limits do not typically apply to Roth conversions.
Traditional IRAs do not place limits on contributions, but you could lose the pre-tax benefits over certain income levels based on the availability of a work retirement plan, household income levels, and tax filing status.
How Are Traditional & Roth IRA Accounts Similar?
- Contribution limits are the same for both a Traditional and Roth IRA accounts. Most individuals may contribute up to 100% of earned income or $5,500 each year. You can choose to add funds to both accounts, but the aggregate amount may not exceed the $5,500 maximum unless you are over 50, which increases the limit by $1,000. Participating in a 401K or other employer plan typically does not exclude you from contributing to an IRA as well.
- Deadlines. You may add funds an IRA account until the tax filing deadline the following year, which is typically April 15.
- Should You Convert Your Existing IRA or 401K into A Roth Account?
The primary benefit of the Roth account requires weighing many options including some unknowns, such as future tax liability and state and federal tax rates in retirement.Changes made in 2010, extended the opportunity of a Roth conversion to more investors, including married couples who file separately, and those earning more than $100,000. The attraction of a Roth conversion is moving funds to a tax-free account with tax-free growth. The biggest downside is the high cost and initial taxation on transferringthe balance.
Factors to consider:
- Distance to retirement. The younger you are, the more years you have where you may obtain tax-free growth. Consider the number of years until retirement as a key factor.
- Current and future income tax brackets. Retirees often pay lower taxes than during working years. However, increases in tax rates and changes in the tax law, make this an unknown variable. Lower overall income and tax-free income can factor into your tax rate in retirement.
- Retirees with income in lower tax brackets could benefit more from a traditional IRA, where low-income years can compensate a conversion without a dramatic increase in taxes.
- State Taxes. Where you will retire will impact future taxation in retirement as some states exclude the taxation of retirement income, including traditional IRA withdrawals.
- When will you need IRA funds for retirement? Traditional IRA accounts require minimum distributions beginning at age 70 ½, based on account balances. Roth IRAs have no such requirement, potentially providing additional years of tax-free growth.
- Higher taxation in the year of the conversion. Adding a significant amount to your income could impact your tax bracket as well as a potential Medicare surcharge of 3.8%, based on income levels.
- How will you pay the taxes in the year of the conversion? Using account funds to pay the taxes could also result in a 10% penalty on the taxed amount because the IRS considers it a distribution.
- Financial aid for college age children. A conversion raises taxable income, which can affect qualifications for financial aid by increasing the expected family contribution and reducing need based aid.
You are not required to convert the full balance, providing the option to spread a conversion over a few years and still gain the benefits without the immediate tax hit. It is also possible to reverse a conversion for a short time after completion.
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