October 3, 2016
You probably have never heard of William Roth, but you may be familiar with his work. Senator Roth was a legislative sponsor of the Taxpayer Relief Act of 1997. That legislation produced one of the great financial planning tools of this generation – the Roth IRA.
A Roth IRA is simply a retirement savings account. A person can open a Roth IRA, contribute to it, and invest as he or she chooses. After-tax contributions (i.e. no tax deduction) go into a Roth IRA, grow tax free, and then withdrawals are also tax free if certain requirements (mostly age and time frame) are met. This is in contrast with a Traditional IRA where pre-tax contributions (i.e. you receive a tax deduction) are made, grow tax free, but withdrawals are then taxed at ordinary income tax rates.
So, why use a Roth IRA?
- Higher future income tax rates: If you are now in a lower income tax bracket than you anticipate being in during retirement (due to higher taxable income or higher future income tax rates) a Roth IRA is a great choice for current contributions.
- Roth conversions: You can transfer part or all your Traditional IRA to a Roth IRA. This is called a Roth conversion. You recognize taxable income now in return for tax free distributions later. This is an incredible opportunity if you currently are in a low tax bracket or have no income tax liability at all. Conversions are also flexible in that you can undo them next year (called a recharacterization) if you change your mind.
- Flexibility: The original amount you contribute to a Roth IRA (your principle) is always free from income tax and penalty, even if the age and time frame requirements are not met. Subsequently, if you don’t know what you are saving for (e.g. retirement, college, or even an emergency fund) a Roth IRA could be a great option. Note: investment gains are subject to income tax and penalty if the requirements are not met.
- Retirement cash flow: If you want to take a distribution from a Traditional IRA in retirement, you need to consider the tax consequences and may need to increase the distribution to pay for the tax. If you want to withdraw $20,000 from a Traditional IRA for a car, you may need to distribute $30,000 to account for the tax liability. With a Roth IRA, if you need $20,000, you take a $20,000 distribution – no tax added!
- No required minimum distribution (RMD): The IRS requires owners of Traditional IRAs to start taking distributions at age 70½. There are no RMDs for original Roth IRA account holders.
- Inheritance: Roth IRAs are the best assets to leave to your heirs. They will have a required minimum distribution over their lifetime, but those distributions are tax free. Compounded tax free growth that passes from generation to generation can really add up, especially if the account is invested aggressively.
As you can see, the benefits of a Roth IRA are many, applying to individuals at all stages of life. So though Senator Roth passed away in 2003, his legacy lives on. Thank you, Senator Roth!