What is a Roth IRA?
In 1997, Congress, under the taxpayer Relief Act, introduced the Roth IRA in to be like a traditional IRA, but with a few attractive modifications. The big advantage of a Roth IRA is that if one qualifies to make contributions, all distributions from the Roth IRA are tax free – even the investment returns – as long as the distributions meet certain requirements. In addition, unlike traditional IRAs, one may contribute to a Roth IRA for as long as you continue to have earned income (in the case of a traditional IRA, one cannot make contributions after you reach age 701/2). The rules for the Roth IRA are found in the Internal Revenue Code under Section 408A.
A Roth IRA is generally subject to the rules for Traditional IRAs.
The most attractive feature of the Roth IRA is that even though contributions are not deductible, all distributions, including the earnings and appreciation on all Roth contributions, are tax-free if certain conditions are met.
Roth IRA Characteristics
The following is an overview of the tax characteristics of the Roth IRA
1. Contributions are not Tax-Deductible: Unlike a Traditional IRA, an individual is not permitted to take an income tax deduction for their Roth IRA contributions. For 2018, the maximum Roth IRA contribution is $5500 ($6500 if the individual is over the age of 50). All Roth IRA contributions are made with after-tax dollars. What this means is that the amount of the contribution is treated as basis in the IRA.
2 .Earning are Tax-Deferred: Earnings and gains from a Roth IRA are tax-deferred and may be tax-exempt if certain conditions are met. What this means is that all income and gains generated by a Roth IRA investment is not subject to income tax so long as the individual Roth IRA holder is over the age of 591/2 and the Roth IRA account has been opened for at least 5 years (a “qualified distribution”).
3. Tax-Free Earnings: The attraction to the Roth IRA is based on the fact that qualified distributions of Roth earnings are tax-free. As long as certain conditions are met and the distribution is a “qualified distribution”, the Roth IRA owner will never pay tax on any Roth distributions received.
Why Establish a Roth IRA?
1. Direct contributions to a Roth IRA may be withdrawn tax free at any time. . Rollover, converted (before age 59½) contributions held in a Roth IRA may be withdrawn tax and penalty free after the “seasoning” period (currently 5 years). Earnings may be withdrawn tax and penalty free after the seasoning period if the condition of age 59½ (or other qualifying condition) is also met. This differs from a traditional IRA where all withdrawals are taxed as ordinary income, and a penalty applies for withdrawals before age 591/2.
2. If there is money in the Roth IRA due to conversion from a traditional IRA, the Roth IRA owner may withdraw up to the total of the converted amount without penalty, as long as the “seasoning” period (currently five years) has passed on the converted funds.
3. Up to a lifetime maximum $10,000 in earnings withdrawals are considered qualified (tax-free) if the money is used to acquire a principal residence for a first time buyer. This house must be acquired by the Roth IRA owner, their spouse, or their lineal ancestors and descendants. The owner or qualified relative who receives such a distribution must not have owned a home in the previous 24 months.
4. Contributions may be made to a Roth IRA even if the owner participates in a qualified retirement plan such as a 401(k). (Contributions may be made to a traditional IRA in this circumstance, but they may not be tax deductible.)
5. If a Roth IRA owner dies, and his/her spouse becomes the sole beneficiary of that Roth IRA while also owning a separate Roth IRA, the spouse is permitted to combine the two Roth IRAs into a single plan without penalty.
6. Assets in the Roth IRA can be passed on to heirs.
7. The Roth IRA does not require distributions based on age. All other tax-deferred retirement plans require withdrawals to begin by April 1 of the calendar year after the owner reaches age 70½. If one does not need the money and wants to leave it to their heirs, this is a great way to accumulate income tax free. Beneficiaries who inherited Roth IRAs are subject to the minimum distribution rules.
8. Roth IRAs have a higher “effective” contribution limit than traditional IRAs, since the nominal contribution limit is the same for both traditional and Roth IRAs, but the post-tax contribution in a Roth IRA is equivalent to a larger pre-tax contribution in a traditional IRA that will be taxed upon withdrawal. For example, a contribution of $5,000 to a Roth IRA for 2018 may be equivalent to a traditional IRA contribution of $6667 (assuming a 25% tax rate at both contribution and withdrawal).
9. On estates large enough to be subject to estate taxes, a Roth IRA can reduce estate taxes since tax dollars have already been subtracted. A traditional IRA is valued at the pre-tax level for estate tax purposes.
Disadvantages of Establishing a Roth IRA vs. Other Retirement Plans
1. Contributions to a Roth IRA are not tax deductible. By contrast, contributions to a traditional IRA are tax deductible (within income limits). Therefore, someone who contributes to a traditional IRA instead of a Roth IRA gets an immediate tax savings equal to the amount of the contribution multiplied by their marginal tax rate while someone who contributes to a Roth IRA does not realize this immediate tax reduction. Also, by contrast, contributions to most employer sponsored retirement plans (such as a 401(k), 403(b), SIMPLE IRA or SEP IRA) are tax deductible with no income limits because they reduce a taxpayer’s adjusted gross income.
2. Eligibility to contribute to a Roth IRA phases out at certain income limits. By contrast, contributions to most tax-deductible employer sponsored retirement plans have no income limit.
3. Contributions to a Roth IRA do not reduce a taxpayer’s adjusted gross income (AGI). By contrast, contributions to a Traditional IRA or most employer sponsored retirement plans reduce a taxpayer’s AGI. One of the key benefits of reducing one’s AGI (aside from the obvious benefit of reducing taxable income) is that a taxpayer who is close to the threshold income of qualifying for some tax credits or tax deductions may be able to reduce their AGI below the threshold at which he or she may become eligible to claim certain tax credits or tax deductions that may otherwise be phased out at the higher AGI had the taxpayer instead contributed to a Roth IRA.
4. A taxpayer who chooses to make a Roth IRA contribution (instead of a traditional IRA contribution or tax deductible retirement account contribution) while in a moderate or high tax bracket will likely pay more income taxes on the earnings used to make the Roth IRA contribution as compared to the income taxes that would have been due to be paid on the funds that would have been later withdrawn from the traditional IRA, had the taxpayer made a traditional IRA contribution. This is because contributions to traditional IRAs or employer sponsored tax deductible retirement plans result in an immediate tax savings equal to the taxpayer’s current marginal tax bracket multiplied by the amount of the contribution. It has been shown that many people have a lower income in retirement than during their working years, and thus end up in a lower tax bracket in retirement, and this is another reason why withdrawals from a traditional IRA or tax deferred retirement plan in retirement are likely to result in a lower tax bill. The higher the taxpayer’s marginal tax rate, the greater the disadvantage.
5. A taxpayer who pays state income taxes and who contributes to a Roth IRA (instead of a traditional IRA or a tax deductible employer sponsored retirement plan) will have to pay state income taxes on the amount contributed to the Roth IRA in the year the money is earned. However, if the taxpayer retires to a state with a lower income tax rate, or no income taxes, then the taxpayer will have given up the opportunity to avoid paying state income taxes altogether on the amount of the Roth IRA contribution by instead contributing to a traditional IRA or a tax deductible employer sponsored retirement plan, because when the contributions are withdrawn from the traditional IRA or tax deductible plan in retirement, the taxpayer will then be a resident of the low or no income tax state, and will have avoided paying the state income tax altogether as a result of moving to a different state before the income tax became due.
6. The perceived tax benefit associated with a Roth IRA may never be realized. For example, one might not live to retirement or much beyond, in which case, the tax structure of a Roth only serves to reduce an estate that may not have been subject to tax. One must live until one’s Roth IRA contributions have been withdrawn and exhausted to fully realize the tax benefit. Whereas, with a traditional IRA, tax might never be collected at all, i.e., if one dies prior to retirement with an estate below the tax threshold, or goes into retirement with income below the tax threshold (To benefit from this exemption, the beneficiary must be named in the appropriate IRA beneficiary form. A beneficiary inheriting the IRA solely through a will not be eligible for the estate tax exemption. Additionally, the beneficiary will be subject to income tax unless the inheritance is a Roth IRA). Heirs will have to pay taxes on withdrawals from traditional IRA assets they inherit, and must continue to take mandatory distributions (although it will be based on their life expectancy). It is also possible that tax laws may change by the time one reaches retirement age.
7. A poor investment, which depletes the value of the Roth IRA, would cause the loss of potential tax-free gains as well as have cost the individual a tax deduction since the contribution to the Roth IRA is after-tax.