A Star Wars reference? Huh? I couldn’t help myself! “May the force be with you” is used in Star Wars to wish people well ; here, in real life, having a Roth is one way to wish your future self well!
What is a Roth?
A Roth is a type of retirement account and can be an IRA (Investment Retirement Account) or a 401(k)/403(b) (employer sponsored retirement plan).
The Roth IRA was established by the Taxpayer Relief Act of 1997 and is named after the senator who initially proposed it, Senator William Roth of Delaware. The Roth 401(k)/403(b) is a new type of retirement account authorized by the US congress and has been in effect since 2006.
I will focus on Roth IRAs. Roth 401(k)/403(b)s, like their traditional counterparts, are employer sponsored plans and employees have little control over which type their employer offers. While many employers now offer them, majority of employers still only offer traditional 401(k)/403(b)s.
The question is, do you ‘Pay Now or Pay Later?’
A Roth IRA is funded using income that has already been taxed, and any earnings (investment growth) can be withdrawn tax-free (subject to the restrictions discussed further down).
To illustrate, let’s say you fund a Roth IRA with $500 from last month’s paycheck (income taxes have already been automatically deducted by your employer) and you invest it in a mutual fund. Let’s also say that 30 years later, your $500 investment has grown to $15,000. You can withdraw all of that money without paying any taxes on the earnings/investment growth of $14,500 (see graph below).
If instead, you invested your $500 in a traditional IRA, you could deduct it from your income and earnings when filing your taxes for that year, which effectively means that you haven’t paid taxes on the $500 (will owe taxes on it at some point). Fast forward to 30 years later, when your $500 has grown to $15000, you now owe taxes on the entire amount ($15,000).
Side note: Some people have expressed confusion about what to invest when it comes to retirement accounts like IRAs and 401(k)/403(b)s. They think that only mutual funds can be invested in retirement accounts, and sometimes use “IRA” and “Mutual Fund” interchangeably. The reality is that a retirement account refers to the type of account, and the rules that govern the account. Think of a retirement account as a vessel or storage unit. You can store investments (mutual funds, bonds, stocks, even real estate) in this storage unit. Once your investments are in the storage unit, you have to abide by the rules of that storage unit.
The most pertinent Roth IRA rules
Max Contribution limits
For 2015: $5,500 or $6,500 if 50 or older
Income limits
Single filers: Up to $116,000 (to qualify for a full contribution); $116,000–$131,000 (contribution limit starts to phase out and is $0 after $131,000)
Joint filers: Up to $183,000 (to qualify for a full contribution); $183,000–$193,000 (contribution limit starts to phase out and is $0 after $193,000)
Married filing separately: $0–$10,000 (contribution limit starts to phase out and is $0 after $10,000).
Withdrawal restrictions
5 year holding period
Must be age 59 ½ to withdraw or will be subject to an early withdrawal tax on the earnings (currently 10%).
There are exceptions to the penalty tax. Some common withdrawals that won’t incur the tax are:
A first-time home purchase (lifetime maximum: $10,000).
Post-secondary education expenses.
Certain un-reimbursed medical expenses.
Health insurance premiums (after you’ve received at least 12 consecutive weeks of unemployment compensation).
Key Takeaways
A Roth can be the way to go for many investors, but it isn’t the only way. In considering a Roth, ask yourself:
“pay now, or pay later?” Will you benefit the most from paying taxes now, or paying later when you may be in a lower tax bracket?
Would you benefit from maxing out a traditional 401(k)/403(b) (with more than triple the contribution limit of an IRA) before contributing to a Roth IRA?
Is converting a traditional 401(k)/403(b) or traditional IRA to a Roth right for you?
Below are a few great links for additional information, and may the Roth be with you!
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