If you're retired and you're looking to benefit from tax-savvy moves, then you might want to consider whether you qualify to contribute to a Roth IRA. Contributing to a Roth in retirement can significantly increase the size of your estate, and in some cases, it can go a long way toward justifying claiming Social Security early. But not every retiree can contribute to a Roth IRA. Read on to find out if you're one of the lucky ones who can.
A little background
Roth IRAs are a retirement savings vehicle that allows people to stash away $5,500 per year, or $6,500 per year if over age 50, in after-tax money that can grow and be withdrawn tax free. But only people with earned income can contribute to a Roth IRA. So if you -- or your spouse -- aren't still working at least part-time, then you won't be able to contribute to a Roth IRA. Social Security income, pension income, and investment income don't count as earned income. Sorry.
However, if you or your spouse does generate earned income, either from working for yourself or for someone else, then you can contribute up to 100% of the Roth IRA contribution limit as long as you earn at least as much money as you contribute.
For example, let's say Mary is a married 65-year-old who consults part-time and earns $13,000 per year. As long as she files her taxes as married filing jointly, Mary can contribute $6,500 to her Roth IRA and another $6,500 to her spouse's IRA, or a combined total of $13,000.
Retiree advantages of a Roth IRA
Contributing to a Roth IRA can make a lot of sense for retirees, because unlike traditional IRAs, Roth IRAs don't require minimum distributions at age 70.5. Therefore, contributions to Roth IRAs can be made throughout your retirement as long as you're earning enough income.
Contributions to a Roth IRA grow tax free, and they can be withdrawn at any time to pay for unforeseen expenses, such as medical costs. Earnings on contributions can grow tax free, too, and they can be withdrawn without a penalty or income tax as long as the account owner is over 59.5 and the Roth IRA has been in existence for at least five years. If money doesn't have to be withdrawn from a Roth IRA, a Roth can be a great way to pass along money tax-free to heirs, too.
After an account holder's death, a Roth IRA becomes an inherited IRA, and that means the required tax-free minimum distribution must begin. However, those distributions will be based on the heir's life expectancy. Therefore, any money that person didn't withdraw every year can be left alone to continue growing tax free throughout the person's expected lifetime. If the heir is young enough, this can translate into tax-free income for decades.
To make use of this strategy, the initial account holder needs to list his or her spouse as the sole Roth IRA beneficiary. Then, when the account owner dies, the spouse should put the Roth IRA in his or her name and then list any heirs as the new beneficiary.
Once the heir inherits the Roth IRA, that person will need to take the first annual minimum distribution by Dec. 31 of the year following the spouse's death. He or she then can stretch out those Roth IRA minimum distributions using one's own life expectancy table.
A Roth IRA and Social Security strategy
If there are other sources of retirement income, including earned income, then investing, rather than spending, Social Security income can make taking Social Security at age 62 a good decision.
To recap, a total $13,000 can be contributed to a couple's Roth IRAs every year as long as they're earning that much in earned income.
Therefore, taking Social Security early and then investing as much of it as possible into a Roth IRA and investing any remaining money into taxable investment account can result in a nest egg that's bigger than waiting until age 70 to opt into Social Security.
That's because the power of compound interest, or the ability for interest earned to earn interest in the future, can outweigh the benefit of delayed retirement credits, which boost monthly Social Security income if the recipient waits until age 70 to begin receiving Social Security payments.
For example, a person born in 1960 would receive 100% of his or her Social Security monthly benefit at age 67, which is the person's full retirement age. If that person decides to begin receiving Social Security checks at age 62, he or she would receive 30% less than at age 67. Waiting until age 70 to opt into Social Security would deliver an amount equal to 124% of what the person would receive at age 67.
Let's do some math. Assuming someone's full retirement age Social Security income is $1,000 per month, taking it at age 62 would result in $700 in Social Security income per month, or $8,400 per year. Of that amount, $6,500 could be put in a Roth IRA, and the remainder could be invested in a spouse's Roth IRA, or a taxable investment account. Overall, if that $8,400 earns a hypothetical 6% interest, it would grow to be worth $259,610 at age 80.
Now, let's assume that retiree waits until age 70, and therefore, he or she receives $1,240 per month. If that person puts as much as possible into a Roth IRA and then invests the remainder in a taxable account, then that $1,240 per month would grow to be worth $196,132 at age 80.
Obviously, this strategy isn't for everyone, and there's no guarantee what an investment will earn in the future, but it does help demonstrate how this strategy might help a retiree who has enough earned income to make Roth IRA contributions.
Regardless, the key to using a Roth IRA in retirement is earned income, and because of that, it may make sense to consider working part-time as a consultant or picking up some shifts at a local store every week just so you can still take advantage of this great tax savings tool during retirement.
To learn even more about IRAs -- both Roth and traditional -- head on over to our IRA Center. We have plenty of advice on all the available options and how to get started.
Retirement planning can seem complicated and scary, but with the right plan and a long-term approach, it's something anyone should be able to tackle. It's also one of the most important things.
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