What is a Roth IRA?

A Roth IRA is an individual retirement account which varies in a number of ways from the Traditional IRA. The principle difference is two-fold. First, contributions are made after taxes and are hence not tax-deductible, as they usually are with a Traditional IRA. Second, earnings on the account not only grow tax-free, but are not taxed when withdrawn during your retirement years, as they are with Traditional IRAs. This means that when the rules are followed, no taxes are ever paid again on withdrawals taken from a Roth IRA.

These are not the only two differences. Other features and considerations are discussed below.

Who Can Contribute to a Roth IRA?

To be eligible to make a contribution you must first have taxable compensation (not taxable income from investments). Whereas contributions to a Traditional IRA may be limited when simultaneously participating in an employer-sponsored retirement plan, the Roth IRA has no such limitations. Instead, Roth IRA contributions are potentially limited by how much compensation you earned during the year (see below).

How Much can be Contributed to a Roth IRA?

Maximum Roth IRA contributions are the same as those for the Traditional IRA. In 2014, the maximum contribution is $5,500 for those under 50, and $6,500 for those who are 50 or older by the end of the year.

The Roth IRA has limitations based on one’s modified adjusted gross income (MAGI). These amounts may change from year to year and it is also advisable to seek professional assistance for the most accurate and up-to-date information. Below is an example for a single person for 2014 (married filing jointly or separately use different amounts):

• The contribution can never exceed your modified adjusted gross income. If your MAGI is only $3,000, then your maximum contribution for that year is limited to $3,000.
• If earning $114,000 or less, the maximum contribution can be made.
• If earning more than $114,000 and less than $129,000, only a partial contribution can be made. The partial amount must be calculated using percentages provided by the IRS.
• If earning more than $129,000, no contribution can be made to a Roth IRA that year.

Roth IRA Contributions are Not Tax-Deductible

Unlike Traditional IRAs, contributions to a Roth IRA are not tax-deductible, they are made with after-tax dollars.

Never-Taxed Earnings within the Account

As mentioned above, when rules are followed, taxes are never paid on withdrawals made from a Roth IRA. This means that the after-tax contributions won’t be taxed again and, more importantly, earnings in the account from things such as appreciation, interest income, dividend income, etc., grow tax-free and remain tax-free at withdrawal.

When are Contributions to be Made?

As with a Traditional IRA, contributions are made prior to or on the income tax filing deadline of April 15, in the year following the applicable tax year. No extensions of this deadline are allowed.

How Can I Invest the Savings?

Investment options depend on a number of factors. Options can be limited when the account is opened directly with, for example, a specific mutual fund company. For maximum investment flexibility it is best to consult an independent financial advisor before opening a Roth IRA.

When Can I Access the Money?

Funds in a Roth IRA are more accessible than funds in a Traditional IRA. Whereas early withdrawals from a Traditional IRA trigger an early-withdrawal penalty, no such penalty is charged on early withdrawals of prior amounts contributed to the Roth IRA. Please take a moment to understand this distinction: there are two sources of money in a Roth IRA, 1) contributions that have been made each year and, 2) accumulated investment income earned within the account on those contributions. Investment earnings cannot be withdrawn early and penalty-free or tax-free, only amounts contributed can be withdrawn at any time penalty and tax-free. The early withdrawal of any of the earnings portion will incur an early withdrawal penalty, presently 10%.

When rules are followed, withdrawals of both contributions and earnings can be made tax-free and penalty-free at age 59 1/2. And, importantly, unlike a Traditional IRA, you are not required by law to make withdrawals starting at the age of 70 1/2. This makes the Roth IRA more advantageous as a vehicle to pass funds to heirs upon death. Heirs pay no income taxes on withdrawals taken from an inherited Roth IRA, but they are required to take distributions over their lifetimes.

Other Benefits of a Roth IRA

• Up to $10,000 can be withdrawn from the account penalty and tax-free to purchase a first home for yourself or certain family members.
• Some earnings can be withdrawn early penalty-free, though not tax-free, to pay higher education costs for yourself or certain family members.
• Unlike Traditional IRAs, you can continue to make contributions to a Roth IRA beyond the age of 70 1/2.
• Contributions may be made to a Roth IRA even if you participate in an employer-sponsored retirement savings plan, such as a 401(k).
• On estates large enough to qualify for estate taxes, a Roth IRA may present tax advantages over assets in a Traditional IRA.

When to Use a Roth IRA or a Traditional IRA?

There is no formulaic answer to this question. It is often advised that younger people who are likely in lower tax brackets than they will be during retirement, are better off contributing to a Roth IRA, whereas those in their highest income years are better off contributing to Traditional IRA’s when their tax rate is likely higher than it will be at retirement. Because there are many other factors at play, it is likely that one will benefit from holding both types of accounts, and making contribution decisions on a year by year basis, depending on one’s specific tax situation for that year. As always, seek important tax advice from a qualified tax professional, as well as investment and planning advice from an independent financial advisor.

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About the Author

Todd E. Frank, CPA/PFS, MBA is the President and CEO of Frank Financial Advisors, a Registered Investment Advisory Firm (RIA) serving clients nationwide from our headquarters in Carlsbad, San Diego, California. As an RIA, Frank Financial Advisors is able to offer truly independent, fee-only financial advisory services.