Understanding Roth IRAs

Undoubtedly, one of the most difficult decisions in financial planning includes whether to save a portion of earnings into either a traditional or Roth individual retirement account – aka an IRA. With an IRA, there comes the question of taxes and how an investment will impact taxes. There are major differences to consider between the traditional and Roth IRA.

According to data from the Investment Company Institute, roughly one-third of the 42.6 million IRA owners in the United States held the Roth version. Opening a Roth IRA provides a huge advantage. With a Roth IRA, there is no income tax on the money withdrawn in retirement, unlike a traditional IRA. With that, Roth IRAs offer a unique set of advantages for retirees when it comes to taxes, distributions and passing on inheritance and unspent savings to the next generation. Though there is no tax on the distributions – or money withdraws – from a Roth IRA, there are taxes that need to be paid toward the contributions put toward the account; hence, a Roth IRA works extremely well for those who expect to be in a higher tax bracket in the future or when they retire; therefore, having a Roth IRA can be a smart tax strategy.

It is important to note that contributions to a Roth IRA are not tax-deductible; rather, income plays a role in how much one can contribute each year. As long as there is an earned income, contributions can be put toward a Roth IRA regardless of age. Contributing toward a Roth IRA does not reduce an individual’s adjusted gross income in that specific tax year since after-tax dollars fund Roth IRA contributions. In other words, there is no tax deduction when depositing funds into a Roth IRA. As a result, a Roth IRA greatly contributes toward building up post-retirement savings. Although there is no immediate upfront tax break, all of the contributions and earnings grow tax-free in a Roth IRA, and after retirement, qualified distributions are tax-free, too.

Individuals can withdraw from their Roth IRA accounts at any time for no apparent reason without being penalized or taxed because there is no required minimum distribution throughout the lifetime. Unlike a traditional IRA, a Roth IRA accrues earnings on a tax-deferred basis and those earnings are tax-free provided the individual meets certain outlined requirements. There are two conditions for withdrawing from a Roth IRA that can ultimately result in higher taxes and penalties. The first condition is that the account holder withdraws earnings before the age of 59½.  The second condition is that the Roth IRA account has not yet reached five years maturity. If Roth IRA earnings are withdrawn prior to these two conditions being met, then the account holder responsible will be taxed and penalized, in which case, there is the potential for higher taxes.

On the contrary, for those who currently have a traditional IRA rather, it may be worthwhile to consider a Roth IRA conversion to receive all the benefits of a Roth account – and to save money on taxes. For every year earnings are withdrawn from a traditional IRA, there are taxes to pay; rather, the funds withdrawn count as taxable income, which significantly increases taxes owed. Not only that, but if the funds deposited into a traditional IRA falls within annual contribution limits, the contribution reduces an individual’s adjusted gross income for the specific tax year.

There are certain tax implications when converting a traditional IRA into Roth IRA that should be taken into consideration. When converting a conventional IRA into a Roth account, understand that there will be “taxes on any money in the traditional IRA that would have been taxed when withdrawn.” In other words, that includes tax-deductible contributions deposited into the account as well as “tax-deferred earnings that have built up in the account over the years. That money will be taxed as income for the year the conversion is made.”  Though there is a huge tax implication when converting a traditional IRA to a Roth IRA, the pay-off is one that can be considered a smart financial decision for taxes after retirement.

Need more information on Roth IRAs and other options? We’d be happy to be of service. Give us a call at 240-395-1060