Source: SeniorLiving.org via Flickr.
There's arguably no better way to secure your financial future than to take advantage of the tax benefits offered by a Roth IRA. These retirement accounts, unlike traditional IRAs, do not allow you to deduct your contributions up front, but they allow you to make tax-free withdrawals in retirement.
Before you open a Roth, you should learn the rules you have to follow and the limits to your participation in them. Here are three things you need to know.
No. 1: Mind the cap
If your annual income is in the six figures, you may not be eligible to contribute to a Roth, because the IRS limits the use of Roth IRAs to those whose income falls below a certain threshold.
For tax year 2014 contributions, Roth IRA contributions are restricted to single taxpayers with a modified adjusted gross income of less than $129,000 and married couples with modified AGI of less than $191,000. Further, the amount of money that can be contributed to a Roth IRA starts phasing out for single filers earning more than $114,000 and married couples earning more than $181,000.
|
Filing Status |
Modified AGI | Maximum Contribution |
|---|---|---|
|
Married filing jointly or qualifying widow(er) |
< $181,000 | |
|
> $181,000 but < $191,000 |
a reduced amount | |
|
> $191,000 |
zero | |
|
Married filing separately and you lived with your spouse at any time during the year |
< $10,000 |
a reduced amount |
|
> $10,000 |
zero | |
|
Single, head of household, or married filing separately and you did not live with your spouse at any time during the year |
< $114,000 | |
|
> $114,000 but < $129,000 |
a reduced amount | |
|
> $129,000 |
zero |
Source: IRS.
If your modified adjusted income is above these limits, you still have options. For example, traditional IRAs do not have income limits, so as long as you have reportable income and are less than 70-1/2 years old, you can still contribute to one -- although income limits might keep you from deducting your contribution on your tax return. Then, if you really want to enjoy tax-free withdrawals in retirement offered by a Roth IRA, you can convert your traditional IRA to a Roth IRA. This can get complicated, especially if you have a mix of deductible and nondeductible IRA contributions in the past. But for many high-income earners, this backdoor Roth IRA option could be a good choice.
No. 2: Will your tax rate go up or down in retirement?
Roth IRAs do not offer an up-front tax break, so the benefit of a Roth IRA's tax-free withdrawals can only be realized if your tax rate will be higher in retirement than it was while you were working.
Let's assume you're in the 25% tax bracket and contributing $5,500 per year to a Roth IRA (the maximum amount allowed for those under age 50 in tax year 2014; those aged 50 and older can contribute an additional $1,000). You'll miss out on the $1,375 tax savings that you could reap by contributing the same amount to a traditional IRA. But in return, you'll be able to withdraw your contributions, plus any gains, free of tax once you reach the age of 59-1/2.
However, if your tax rate has fallen to 15% by then, the tax bill on that $5,500 withdrawal will be only $825 -- that's $550 in tax savings you missed out on by opting for the Roth. So, if you expect to drop into a lower tax bracket in retirement, then a Roth IRA may not be the best choice.
No. 3: Here's to your health
If you think you'll need to tap into your Roth IRA savings during retirement rather than pass them along untouched to heirs, then you really should take an honest look at your health and your family's health history.
By choosing a Roth IRA instead of a traditional IRA, you're assuming that you'll live long enough to enjoy the tax benefit of those tax-free withdrawals. That may be true, but it's important to consider your health and your likelihood of living decades into retirement, especially if you'll be relying on Roth IRA withdrawals for income.
Lots to keep in mind
Undeniably, there are a lot of things to consider with Roth IRAs. Roth IRAs are a great option for people who expect that their tax rate could climb, rather than fall, in retirement. They can also be a great choice for people who don't expect to tap their Roth IRA for retirement income because Roth IRAs, unlike traditional IRAs, don't require you to make withdrawals in your lifetime, which can make them a valuable tool for legacy planning.
Regardless, don't let these considerations keep you from contributing to your retirement savings. After all, the contributions you make today could mean the difference between financial security or hardship in your golden years, which makes forgoing retirement savings a huge mistake.
