An Introduction to ROTH IRAs

Individual Retirement Accounts (IRAs) come in two forms, they are either called a Traditional IRA or a Roth IRA. Both of these have annual salary cap restrictions, which change each year and are different based upon your filing status. They operate on a Phase Out system, as follows:

Roth IRA Salary Limits 2014

Traditional IRA Salary Limits 2014 (with no company plan in place)

 

Traditional IRA Contribution Limits (with company plan in place)

Note that the salary restrictions kick in a lot earlier when your company has a defined benefits plan in place (such as a 401(k) or SEP,etc)

Tax Treatment

• Tradition IRA – Pre tax deduction today, Tax Deferred growth tax is payable on withdrawals in retirement.
• Roth IRA – Post tax contribution today (no deduction), funds grow tax free, and no tax is payable on withdrawals in retirement.

Differences between IRAs and Standard Brokerage Accounts

Both IRAs, along with other retirement vehicles such as 401Ks are Tax Advantaged Accounts. This means that the profit that your investments earn are not taxed for capital gains when you sell positions. This means that you get to keep more of your money. The flip side of this is that while you are not subjected to capital gains, you cannot claim capital losses, so if the value of the account position drops you can’t write this off. This is important when considering where to locate higher risk positions.

Tax Advantaged Accounts come in two forms- Tax Deferred Accounts and Tax Free Accounts

Most people who have a retirement account have a Tax Deferred Account, this is the Traditional IRA, the company 401(k) or 403(b) et al. Most company plans are like this, though there is a Roth 401(k) available, fewer companies offer it. Tax Deferred means you will be paying taxes later on in life, once you start withdrawing from the account.

Save now, or save later – if you contribute to a Tax Deferred Account you get to deduct the contribution from your annual salary, and then your Income Tax is calculated at the new lower rate:

Tax Deferred Example – you earn $40,000 Gross Salary, you contribute $5,000 to a Traditional IRA. Your Tax basis for Income tax now becomes $35,000, which means your tax bill will reduce by about $1200-$1500 depending on where you live. That’s just straight cash into your pocket for opting to save for your retirement! The catch- when you start withdrawing from the account in retirement the Government will tax that distributed money as income, so you will pay out on the appreciated amount.

EG if that $5,000 grows to $50,000 your tax liability might be $50,000 x 30% or $15,000. 10x the amount you saved earlier.

Tax Free Example – you earn $40,000 Gross Salary and contribute $5,000 to a Roth IRA. Your Tax basis for Income tax remains at $40,000, so you pay more than if you had put it into the Traditional IRA this year. The difference – when you withdraw the money you don’t declare it as income. In your retirement this money is tax free for you, so even if your $5,000 grows to $50,000 you still pay no tax on withdrawals.

7 Facts about ROTH IRAs

1. Anybody, including Minors, can contribute to ROTH IRAs, however they can only contribute if they have earned income for that year.

Earned income includes all the taxable income and wages you receive from working. Some examples of taxable earned income include:-

• Wages, salaries, tips, and other taxable employee pay
• Long-term disability benefits received prior to minimum retirement age
• Net earnings from self-employment if you own or operate a business
• Gross income received as a statutory employee

Some examples of income that is not considered eligible income for determining IRA contribution eligibility are:-

• Earnings and profits from property
• Retirement Income
• Disability income
• Foreign earned income
• Social security
• Unemployment benefits
• Child support

2. Roth IRAs need a 5 year seasoning period for earnings to be non-taxed.

If you withdraw sooner than 5 years gains (but never your contributions) are subject to taxes, so they are best set up well before you need them. And, if you are under 59 1/2 years old you will pay an additional penalty for withdrawing of 10% on those earnings, unless certain exemptions occur, these could be:

• Death
• Disability
• Equal periodic payment withdrawals over owner’s life expectancy
• Medical expenses greater than 7.5% of Adjusted Gross Income
• Health insurance premiums for an unemployed person
• Qualified higher-education expenses
• First-time home purchase (up to 10K)

3. Roth IRAs can be bequeathed to your beneficiaries

Roths passed to spouses benefit from the unlimited spousal gifting rules, but if passed to an heir or other beneficiary they are subject to the lifetime exclusion amount. The amount changes annually, in 2014 it is $5.34M.

The Inherited Roth would afford the same tax treatment in that earnings would be taxable if the account is less than 5 years old, but contributions would not be.

4. There are no minimum required distributions from Roth IRAs

Traditional IRAs force you to start withdrawing a minimum annual distribution from the age of 70.5, the ROTH does not. Many people will continue to fund Roth IRA plans during retirement years as a vehicle to pass down wealth.

5. You can still contribute to ROTH IRAs when you have paid in the full amount to 401(k) 403(b) and SEP-IRAs

You can contribute to a Roth IRA even if you have contributed to a 401(k) that year. If you have a SEP IRA you can fully contribute to the Roth if you haven’t used the Employee contribution of the SEP.

You can also split your money between a Roth IRA and Traditional IRA, but the sum of both IRA accounts cannot exceed the annual cap ($5,500 in 2014).

6. ROTH IRAs are Investment Vehicles for your Retirement.

They can be kept with most of the major Brokerages, or with modern alternative firms like Betterment. Within them you can hold cash, or actively trade stocks, funds, and bonds without capital gains. Once the money is in the Roth it is free to grow, and you can build whatever strategy you like for the money within Roth IRAs.

7. The Deadline for establishing ROTH IRAs is April 15th – for the previous year of earnings.

You can fund up to the annual maximum for last year by April 15th of the following year. The 2014 limit is $5,500 and it increases on a fairly regular basis.