What is a Roth IRA and How Does it Work?

Roth IRAs are a form of an Individual Retirement Account, which not only provide tax-free growth potential, but also a qualified distribution of earnings is tax-free.  You contribute to a Roth IRA using after-tax money, making the contribution not tax deductible.  

Roth IRAs have the same contribution limits as a Traditional IRA, $5,500 per individual with a $1,000 catch-up contribution allowed for individuals age 50 or older, for 2016.  IRA contribution limits are aggregated, meaning that you can only contribute the maximum amount whether in a Roth, Traditional, or split between the two.

Roth IRAs are an excellent planning tool; however, they have specific requirements for contribution that are unique to Roth IRAs.  If your Modified Adjusted Gross Income (MAGI) for 2016 is between $117,000 –$132,000 for a single filer or between $184,000 – $194,000 for married individuals filing jointly, then your contribution amount may be reduced or not allowed.  Another feature is, unlike a Traditional IRA, Roth contributions are allowed after the age of 70½ if you, or your spouse if filing jointly, have earned income, MAGI limits apply. Additionally, you are not required to take Required Minimum Distributions during your lifetime.

There is also the ability to convert your Traditional IRA to a Roth IRA.  This could also be done with your employer-sponsored retirement plan if you have a triggering event such as separation from service.  The three most important factors to consider with this are:

  • Do you expect your tax bracket to be the same or higher in retirement than it is today?
  • Do you have the funds, outside of retirement accounts, to pay taxes due on the Roth conversion?  
  • The accumulation period, the longer the assets stay in the Roth IRA the greater the benefit of tax-free accumulation and future tax-free distributions. 

Another little known fact about Roth IRAs is that they can be established for minors.  Traditional IRAs can also be established for minors; however, it is unlikely that their earnings will be significant enough to take advantage of the tax-deductibility of the contribution.  While saving for your child’s retirement may be the last thing on your mind, and theirs, it has significant benefits and can be used as a valuable teaching tool.  Most people are intrigued by the concept of compounding and while the child won’t truly understand interest rates and compounding, they will see their money growing.  Roth IRAs can also be used inadvertently as a college savings tool.  Currently, funds in a Roth IRA can be withdrawn and used for qualified higher education expenses without the 10% IRS penalty tax.

While Roth IRAs have their advantages, it is important to talk with your tax advisor to determine if this is the right option for you.  My team and I welcome the opportunity to discuss this and any other retirement planning needs with you.

This article was written and provided by Michelle Floyd, CFP®, Financial Consultant with Axiom Financial Strategies Group in New Albany, IN.  She can be reached via email at [email protected].com or phone at (812) 948-8475.  Visit our website www.AxiomFSG.com.

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