Likely, the single biggest game changer in my 31 year career for savers was the concept of the Roth IRA rather than tax-deferral saving via the traditional IRA. The Roth IRA and Roth 401k allow you to pay taxes on the money you save today but you never pay taxes on the growth. These are simple principles on one hand but mixed with multiple and complex rules on the other hand.
Whether you should you use a Roth IRA or 401k is a question I could never answer in 500 words! The general rule is that if you believe your marginal tax rate will be higher in the future then a Roth account may be right for you. The ability to invest in a Roth IRA is limited by your earned and total income. The Roth 401k is not limited by your income but has to be offered by the company plan where you work. According to CNBC and Willis Towers Watson survey of large and midsized companies, 7 out of 10 now offer a Roth option within their 401(k) plans. That's up from 54 percent who did in 2014 and 46 percent in 2012.
The biggest confusion seems to stem around the 5 year rules for the Roth IRA plans. There really are two types of Roth IRA’s – contributions where you had earned income this year and made below in the income restrictions imposed by the IRS; and Roth conversions where you took money out of an existing IRA or 401k plan and rolled that money into the Roth IRA.
With a Roth IRA contribution it is important to note that the funds you invest did not have to be earned in this calendar year. You must have had earned income for that year but it doesn’t have to be those funds. For instance, you have a savings account at the bank and qualify to make a Roth IRA contribution this year. You can take the money from the savings account – possibly earned years earlier – and use that to make the deposit. A Roth contribution always allows you to get your money back out tax free at any time!
After 5 years of having your first Roth IRA account opened, you can actually take out even the growth for IRS approved reasons like purchasing your first home. This strategy is often overlooked and the result is accounts that could have been tax-free forever still paying dividends to the IRS today!
The conversion is much more complex and I would strongly encourage a planning firm with significant experience in the process. There are great opportunities with the Roth IRA and Roth 40k but there are also pitfalls to be considered. There is an annual clock on making these decisions and many times people simply don’t get around to making the decision or taking action before the time has passed to be eligible.
Roth IRA’s are not subject to Required Minimum Distributions (RMD’s) though inherited Roth IRA’s and Roth 401k’s are subject to the RMD. Plan wisely for the taxman will come for their due.
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