A Roth IRA is a retirement savings account that allows you to contribute after-tax dollars. This means you pay taxes now instead of paying them when you use the contributions or earnings (interest, capital gains, or other investment income) at the current Roth Ira retirement age of 59 1/2. This can be a powerful tool in a forward-thinking tax plan. Here are some pros and cons of Roth IRAs.
Pros:
- Lower your taxable income and tax rate in retirement or semi-retirement if you are still earning income.
- A current perk for qualified first-time home buyers is that if the account has been open for at least five years you can use up to $10K towards a down payment. Say you invested $5,000 when you were 18 years old and it grew to over $10,000 by the time you are 30 when you are ready to buy a first home. You could use $10,000 of your earnings towards your down payment, tax free and penalty free.
- You can withdraw your contributions (not your earnings) before retirement age without penalty. This can be helpful if you need access to your assets.
- There are no RMDs (required minimum distributions). 401(k)s and other accounts require that you start withdrawing a certain percentage each year once you reach a certain age. If the stock market has a downturn during your RMD years you could be forced to pull investments at a loss. Or, if you are still working and earning substantial income past the RMD age, you could pay higher taxes on the income you don’t need yet. Roth IRAs don’t have RMDs to plan for.
- Estate Planning: Roth IRAs are a good estate planning tool because they can be inherited tax-free by your beneficiaries as long as you held the account for five years. Inheritors are required to take RMDs.
Cons:
- Roth IRAs have both income limits and contribution limits. The contribution limit in 2023 is $6,500 ($7,500 if you’re 50 years or older), provided that your income is not over the limit.
- You can’t access your earnings before retirement age without penalty. There are exceptions to this rule.
- Many five-year rules tie up your investments for a substantial time.
Be sure to follow IRS rules on the earned income qualifications, how much you can contribute each year, and when it can be used. Rules can change from year to year.
Now, what is a Roth IRA Conversion?
A Roth Conversion is the process of moving your money from a Traditional IRA or another qualified employer-sponsored retirement plan such as a 401(k), 403(b), or 457(b) into a Roth IRA account. Why do this?
Many take advantage of employer match programs in their 401(k)s. 401(k)s also lower taxable income during high-earning years. However, many 401(k)s have limited investment fund options and high fees. Plus, they are subject to taxes as well as RMDs in retirement. So, if someone has a lower income year, they may choose to convert their 401(k) assets into a Roth. Some also convert to a Roth IRA because they believe their tax bracket will be higher in retirement (either because they have a lot invested for retirement, a large inheritance coming, or they think all future tax rates will be higher.
Here’s an example of when someone may choose to complete a Roth Conversion. Say you are laid off or resign from your job. This results in a lower income than usual for a year. If you have an ample saving account, it can be a great time to convert in the year your income is lower since you will be in a lower tax bracket. The ample savings is critical because you will owe taxes on the money you convert.
Pros:
- More investment options.
- Tax-free growth and withdrawals: Once the money is in a Roth IRA, it grows tax-free, and you can withdraw it tax-free in retirement.
- No Required Minimum Distributions (RMDs): Unlike traditional IRAs, Roth IRAs don’t have RMDs, so you can leave your money in the account as long as you want.
- You can access the contributions once qualifications are met.
Cons:
- Paying taxes upfront. The amount you convert is taxable income for the year you convert. It may not be the right move if you don’t have the cash to pay the taxes.
- Potential for higher taxes. If your tax rate is lower during retirement than when you convert you could pay higher taxes on the converted income.
- Temporarily losing access to money. Once you convert the money to a Roth IRA, you can’t withdraw the converted funds penalty-free for at least five years. It may not be the right move if you need the money before then.
A Roth Conversion can be a useful tool. Be sure to understand all IRS rules before converting. Take note of Roth IRA five-year rules and tax implications. There are also time restrictions that can incur costly penalties if not executed properly. Be sure to consider and understand your circumstances before making any decisions.