Partner and Financial Planner at Blue Rock Dravo Bay. Financial Planning is just that, planning for the expected and the unknown. My strongest commitment to clients is to be a familiar, trusted face during their time of need.
While every investment account is special in its own way, few offer as many resources, benefits, and flexibility as a Roth IRA. Investing in a Roth IRA presents many unique financial planning advantages that can help you reach your goals both now and in the future.
Our financial planning philosophy is all about harnessing your resources and aligning your money with your goals—Roth dollars are simply another way to help achieve that mission.
Why is a Roth IRA like your financial royal flush? Let’s take a look.
What Makes a Roth IRA Special?
Roth accounts differ from other tax-advantaged retirement vehicles in one central way: taxes. A Roth IRA is funded with after-tax dollars, investments grow tax-deferred i.e. interest, dividends, and capital gains aren’t taxed, and all qualified distributions are tax-free.
The opposite is true for a traditional IRA, where contributions are deductible (within certain income limits and if eligible for an employer-sponsored plan) and distributions are taxed as ordinary income.
Roth IRA Rules
What counts as a qualified Roth distribution?
- You withdraw funds after reaching age 59 ½.
- In the event of an employee disability or death.
- Your withdrawals (contributions and earnings) adhere to the 5-year rule.
While you can always withdraw base contributions from your Roth IRA prior to 59 ½, investment gains must be compliant with the 5-year rule to avoid taxes. Direct contributions to your Roth IRA can be withdrawn at any time, but any gains and conversions are subject to this 5-year freeze.
Say you contributed $5,000 to your Roth IRA and in three years the value appreciates to $7,000. You can only withdraw the $5,000 tax-free—any more, and it would be subject to tax and a potential early withdrawal penalty.
Roth IRAs also carry income thresholds for contributions. In 2021 if your modified adjusted gross income exceeds $140,000 for single filers and $208,000 for those married and filing jointly, you can’t directly contribute to the account.
These limits, however, don’t fully exclude high-income earners from taking advantage of Roth accounts. There are several strategies to indirectly contribute to a Roth like a Roth Conversion or Mega Backdoor Roth IRA, both of which we’ll dig into a bit later in the article.
Increasing Strategic Opportunities
There aren’t too many ubiquitous aspects of finances, but taxes are certainly one of them. Taxes are a mainstay both during and after your lifetime. No matter what, each dollar you earn will be taxed, so why not structure your finances to be taxed at the most advantageous rate? Roth IRAs give you the opportunity to build a strategy around paying your taxes—choosing the best time to either pay or defer your tax bill.
For those who are fresh in their careers, a low tax-bracket, and projected higher future earnings, Roth IRAs are likely a good addition to your plan. However, for those nearing retirement and earning their highest projected salaries, Roth IRAs stop making as much sense. It all comes down to building a sustainable plan both now and in the future.
Roth Accounts Bring Flexibility To Your Retirement Withdrawal Strategy
Roth’s are funded with after-tax dollars, making qualified distributions tax-free in retirement. This option opens up a whole host of strategies to supplement your income and lifestyle needs in retirement.
Employing Roth dollars offers a more tax-efficient way to make up deficits in your income plan. Instead of withdrawing funds from your brokerage account, which could stick you with a 15-20% long-term capital gains rate, qualified Roth withdrawals won’t cost you a thing.
Since Roth distributions don’t add to your taxable income, you could see immense tax savings in your retirement years. Saving on taxes can also go a long way to extending the life of your investments. Many retirees worry about running out of money and structuring your withdrawals with your goals, lifestyle, and taxes in mind can provide a longer shelf-life.
Because you pay tax upfront, Roth IRAs are one of the few accounts that don’t adhere to the required minimum distribution rule, meaning you are free to withdraw your money as you need it—not when the IRS tells you to.
Roths Can Help You Achieve Financial Goals Now
Think about your finances like a toolbox. Each tool is unique and designed to help you complete a project. Depending on your needs, different tools can help you accomplish the task. You wouldn’t use pliers to hang a picture on a wall, for example, just like you wouldn’t use a Roth account to fund your entire retirement savings plan.
Roth accounts simply add another tool to your financial toolbox. Yours might include a mix of brokerage, retirement, and Roth accounts. Supplementing those could be securities backed line of credit, health savings account (HSA), emergency fund, and more.
Making good use of your Roth accounts provides unique opportunities to save money, but this strategy isn’t reserved for retirement. Roth accounts can be critical devices during your working years. There are several provisions to withdrawing money from a Roth IRA in your working years without having to pay a 10% early withdrawal penalty.
- First-time home purchase (up to $10,000)
- College costs (qualified expenses like tuition, fees, and books)
- Birth or adoption expenses
As you can see, Roth IRAs can give you the tools to further your goals both now and in retirement. Life changes, and it’s good to know that you can use funds in a Roth IRA to help bring certainty in times of change.
Top Tips To Make The Most Of Your Roth IRA Overtime
A Roth IRA can be a great financial resource throughout your life. Here are some top tips to help you get the most out of your Roth IRA.
- Consider a Roth Conversion/Backdoor Roth IRA in lower-income years. Roth Conversions allow you to convert funds from a traditional IRA to a Roth IRA. This strategy enables high-income earners to take advantage of Roth IRAs without directly contributing to them. As a general rule of thumb, those in the 24% tax bracket or below would benefit from a Roth Conversion whereas those in the 32% tax bracket or higher should avoid or defer. This is, of course, subject to change depending on your earning trajectory.
- Prioritize Roth contributions throughout your working years. Many people will earn more money as they expand into their careers, making their early, low-tax years ripe for Roth contributions. Remember, contributing to a Roth isn’t the best choice for everyone. Working professionals at their peak earning years, for example, shouldn’t make Roth contributions a big part of their strategy.
- Think about a Mega Backdoor Roth IRA. This strategy converts after-tax funds from your 401(k) to a Roth IRA. When used appropriately, it can allow you to contribute upwards of $30,000 to your Roth IRA. There are several strategic decisions to making this tool work, so talk with your financial advisor and tax professional before initiating any transfers.
- Start early. As with most financial advice, the earlier you can contribute to a Roth IRA, the better. That way, you can take advantage of the tax benefits and compound savings.
Keep in mind that there are important tax stipulations with both the backdoor and mega back door Roth IRA strategies, most notably the pro-rata rule. This rule requires you to consider the balance of all your IRAs when determining the taxes you’ll owe on the conversion.
The IRS instituted this rule so that people couldn’t simply convert non-deductible a.k.a after-tax IRA funds to Roth IRA funds, as a work-around to avoid the income limits applied. This aggregation rule can, however, be avoided by contributing to a 401(k).
When it comes to a mega backdoor Roth IRA, remember this: make a full distribution. A full distribution is the only way this strategy would benefit you. If you want to learn more about this strategy, give us a call.
Roth IRAs present many opportunities to further your financial goals both now and in the future. When used correctly, you are able to add more flexibility and freedom to your spending while also controlling your tax liability. Are you ready to see how a Roth IRA can advance your financial life? Set up a time to talk with our team today.