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ROTH IRAs and Your Financial Plan

ROTH IRAs and Your Financial Plan

August 29, 2021

What is a Roth IRA?

Hi everyone, and welcome back to Melissa Making Cents!

As a CERTIFIED FINANCIAL PLANNER™ and a financial coach, I understand that there are few topics like retirement that lingers in the back of people's minds. When, where, and how you will retire are looming questions that constantly circle and infringe on people's thoughts almost universally among Americans. It's for good reason that people worry about retirement! It's good to have a plan of what you're going to do once past the "good working years" when we earn the majority of our money. However, about a quarter of all Americans don't feel like they're on track to retire. 

The troublesome part of not knowing or worrying that you aren't on track to retire is just that… If you don't know, that means you aren't measuring, which can pose serious issues. Having someone help you along the way by creating a plan of how much you'll eventually need and how you're going to get there are essential in planning for the golden years. Financial planners, financial advisor representatives and financial coaches are the bridge that helps you get there. We estimate, calculate, and create individualized plans to help you achieve your goals. 

One of the tools and strategies in the back pocket of many financial professionals is called a Roth IRA. We've all heard of a Roth IRA, but fewer of us know what it is. Today, we'll be going deep in detail about what a Roth IRA is, how it functions, who can have one, and more. We'll go into as many specifics as possible and answer all the questions we can think of! 

What is a Roth IRA?

Melissa Cox CFP explains ROTH IRAs

Let's hop into it! IRA stands for Individualized Retirement AccountThese are essentially accounts that can hold many different types of investments and assets. They function as an incentivized savings and investing account. The incentives and tax advantages with IRAs are geared towards creating long-term growth. In other words, an IRA is a tax-advantaged account meant to incentivize its holder to save and invest money towards the future (mainly retirement). 

The Roth part of the Roth IRA indicates how the account will be taxed, which we'll get into later on. Roth IRAs are commonly confused with traditional IRAs and 401(k)s, which are other types of accounts that one can use to save for retirement. 

The Rules of a Roth IRA

Melissa Cox CFP explains the rules of a ROTH IRA

With Roth IRAs and all other types of retirement accounts, you're held to a set of rules by the IRS. These rules determine how you're able to use your account, how much you can contribute, how it is taxed, and how/when you will be able to withdraw money from the account.

(Keep in mind I am not a tax advisor, so I'd suggest you schedule an appointment with your CPA to talk about the tax aspects of a ROTH IRA and your personal financial plan)

With Roth IRAs, your maximum contribution limit for 2021 is $6,000 if you're under the age of 50 and $7,000 if you're 50 years of age or older. However, this all depends on whether or not you're eligible to contribute to an IRA or not. If you file taxes as Single, you must make under $125,000 per year to make that maximum contribution. If you file taxes as Married Filing Jointly, you and your spouse's combined income cannot exceed $198,000 to contribute the full amount. 

If you earn more than that, the maximum contribution works on a sliding scale. In other words, the more you make, the less you can contribute annually. Once your income reaches $140,000 (Single) or $208,000 (married filing jointly), you will no longer be able to contribute to your Roth IRA and will have a $0 maximum contribution. 

Why most are attracted to Roth IRAs, and the meat of its rules are really its tax advantages. While you won't get any tax write-offs (quite the contrary), your contributions will be taxed pre-contribution instead of at withdrawal. You can think of this as doing a little work on the front-end instead of a lot of work later on. In addition, once your contribution (in cash) is made to your Roth IRA and taxed, you'll then be able to invest without worrying about paying taxes on your gains at withdrawal. 

Roth Versus Traditional IRAs

Melissa Cox CFP differentiates ROTHS and Traditional IRAS

While there are several differences between Roth and Traditional IRAs, by far the most notable difference is how they are taxed. Like I explained earlier in this post, Roth IRAs main advantage tax-wise is that taxes are immediate, and you are later allowed to reap their growth without being taxed. Traditional IRAs are almost exactly the opposite. With a traditional IRAs tax-deferred status, you'll immediately write off your contributions to the account and pay taxes when you withdraw that money in retirement. Another notable difference between the two main IRAs is that in Traditional IRAs, you must begin taking required minimum distributions at age 72. 

The discussion between Roth IRAs and Traditional IRAs more often than not leads to someone asking, "Which is better?". It's difficult to say which IRA is better because the answer is highly individualized. If you believe that you'll be in a higher tax bracket down the road, a Roth IRA may be the best option to minimize taxes on the front-end. However, it must also be considered that you're limiting the snowball effect of compounding interest by immediately taxing your contributions. Ultimately the decision about which type of IRA is best for you should be something you discuss with your CERTIFIED FINANCIAL PLANNER™, who can account for variables in your lifestyle, income, and future. 

Roth IRAs Versus 401(k)s

Melissa Cox CFP talks about ROTH vs 401ks

Another commonly used type of retirement account is a 401(k), which is also at times mixed up with Roth IRAs (and IRAs in general). 401(k)s are typically offered by employers. While Roth IRAs can be offered by employers, they don't necessarily have to be. 401(k)s also usually provide some sort of employer contribution matching, which isn't typical of IRAs. Lastly, 401(k)s are generally tax-deferred (similar to a traditional IRA). This just scratches the surface on 401(k)s and what they are. To learn more about 401(k)s and employer matching, feel free to read my recent blog post 401(k) and Employer Matching in Your Financial Plan.

What Can You Have Inside a Roth IRA

Melissa Cox CFP talks about investing in a ROTH IRA

Let's start by getting something out of the way. Contributions to a Roth IRA must be made in cash (or check). However, once money is in the Roth IRA, it can be used and invested in various ways to create growth and appreciation. Some of the ways you may invest money once it's in a Roth IRA are exchange-traded funds (ETFs), stocks, bonds, mutual funds, and CDs. While the IRS is pretty loose with what you may use your IRA funds for, your bank or custodian may have additional rules which you should be aware of.

What Happens if You Go Over Contribution?

Melissa Cox CFP talks about going over ROTH Contributions

First off, if you're working with a great financial planner (wink, wink), you should be well aware of your maximum contribution and know when to stop contributing. However, things happen, and you might go over for a number of reasons. One of the most common reasons people accidentally over contribute to their Roth IRA is because either the person or their spouse receives a raise. This can lower your maximum contribution, and before you know it, you've accidentally over contributed.   (See why it's handy to keep your CPA in the loop!)

Over contribution will be subject to a 6% tax rate for every year that it sits in your account. If this happens, the best course of action is to talk with your financial professional about your best path forward. According to Investopedia, three things you can do are recharacterize your contribution, withdraw your contribution overage, or apply your contribution to a future year. 

When Do You Have to Take Money out of a Roth IRA?

Melissa Cox CFP talks about taking money out of your ROTH IRA

If you're familiar with other types of retirement accounts, you're probably wondering about required minimum distributions. If you're unfamiliar with required minimum distributions (or RMDs), please read my blog post regarding them here. To summarize them, a required minimum distribution is when the IRS or other entity requires you to begin withdrawing money at a specific age. 

The reason for having a required minimum distribution is that you must eventually pay the piper. Some types of retirement accounts that require tax-deferred RMDs ensure that you don't skirt around paying the IRS while continuously growing your money tax-free. However, Roth IRAs aren't tax-deferred. Because of this, there are no required minimum distributions in the original account owner's lifetime. You're free to withdraw (or not) once you reach the age of 59 and a half. 

If you've received an IRA as a beneficiary, other rules will apply to you, which you will need to familiarize yourself with. I've laid out many of these rules in an earlier blog post, which you can read here: Beneficiary IRAs and Your Financial Plan.

Roth IRA Withdrawals

Melissa Cox CFP explains ROTH withdrawals

Okay, so there aren't really required minimum distributions for the original account holder. That leads us to our next topic. What happens, and how do you make withdrawals from your Roth IRA? Let's start off by defining a few terms. Qualified Distribution is when your withdrawal can be accomplished both tax and penalty-free. If your withdrawal incurs penalties or taxes, it is defined as a non-qualified distribution. Where qualified distributions aren't subject to taxes or penalties, non-qualified are subject to taxes and or 10% penalties.

To determine whether or not your distribution is qualified or non-qualified depends on a few factors. First, it depends on whether or not you're withdrawing contribution money or earnings. At any time during your life, you're able to withdraw however much you've contributed to your ROTH IRA without taxation or penalty (qualified). However, if you're withdrawing earnings, it becomes a bit more complicated. 

To withdraw money from earnings, you must be over 59 1/2, be purchasing or building a home for yourself or an immediate family member, have become disabled, or be the beneficiary of a Roth IRA. In addition to this, you must meet the Five Year Rule. The Five Year Rule states that you must allow five years to pass from your first contribution to any Roth IRA before you withdraw earnings tax-free. 

History of Roth IRAs

Melissa Cox CFP gives the history of the ROTH IRA

The IRA has been around for quite some time. However, the Roth IRA is relatively new in comparison to IRAs in general. These types of individualized retirement accounts were created in 1997 with the passage of the Taxpayer Relief Act of 1997 and were named after their principal sponsor Senator William Roth. Roth IRAs were designed to provide two things: immediate taxation to individualized retirement accounts and to allow Americans to keep all of the gained income from investing. 

Because of the way it is structured, the Roth IRA has come under some scrutiny from economists. While the creation of Roth IRAs has been great for investors who take advantage of its tax structure, some worry about the loss of tax income from the Roth IRAs possibly explosive generation of wealth. For example, it is estimated that the Treasury will lose $14 billion between 2014 to 2046 in tax revenue due to Roth IRAs.

A CERTIFIED FINANCIAL PLANNER™ Can Help You Make the Decision if a ROTH IRA is Right for You

As a CERTIFIED FINANCIAL PLANNER™, Melissa Cox helps analyzes ROTH IRAs in financial plans

The truth is that there are tons of options out there when it comes to retirement and retirement accounts. Traditional IRAs, Roth IRAs, and 401(k)s are some of the most common forms of retirement planning, but they're only the tip of the iceberg. Knowing what route to take can often be confusing and overwhelming. That's where people like myself come into the picture. A financial planner or financial advisor can walk you through the process step-by-step. We're knowledgeable professionals who want to help you make the best choice for yourself and your family. 

Making decisions about retirement accounts is difficult but not impossible! The help of a professional can make the process much easier. If you're interested in talking or meeting to discuss your options, please, feel free to call or email to schedule an appointment with me. Together we can create a financial plan that helps you become debt-free, make a savings security blanket, and put your money to work for you!

Schedule a call with Melissa Cox CFP®

Until next time...this is Melissa Making Cents!

Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.

Read last week's blog post by Melissa Cox CFP®