Question: I have tried reading the IRS bulletin on Roth IRAs but still have a question. If you are over 59 1/2 and have owned a Roth IRA for at least five years, are the distributions (including any income you have gained) tax free? Is it wise to invest in a Roth? Why?
Answer: The easy question to answer is your first one: yes, every dollar you take in that situation is free of all taxes and penalties, including all earnings. The whole point of a Roth IRA is to deny an initial tax deduction for contributions in exchange for making ALL distributions tax-free once the required five years and age 59 1/2 requirements are satisfied. Of course, the greatest benefit from a Roth occurs when you delay distributions as long as possible rather than take them as soon as possible, so I’d generally look for other sources of cash before ending the enormous benefit of tax-free growth on invested amounts. But if you must, you can do so tax-free.
Now the more complicated question: why is it wise to invest in a Roth? It definitely IS wise and if you’re eligible, I suggest you max it out. Why? Well, you asked for it:
- Full Roth IRA contributions, $5,500 for those under 50 and $6,500 for those over in 2014, can be made by anyone with earned income (or alimony) whose total income falls under $114,000 if single and $181,000 if double. (Full contributions can be made to Roths for each spouse even if only one has earned income as long as total income is below the $181,000 limit.) Above those amounts, it phases out. I’ll leave out the details, which change annually. Contributions are allowed even if the taxpayer is covered by a retirement plan through employment, unlike traditional IRAs, whose tax-deductible contributions are limited in such cases unless overall income is relatively low.
- Contributions can be withdrawn at any time without any taxation or penalty (even the day after the contribution). For this reason, I think the first dollars saved by a young earner should go into the Roth even if it is an emergency fund. If you can only save $5,500 in your first year of employment, you might as well put all of it where earnings can accumulate tax-free, even if you might need to withdraw the contribution itself in an emergency. Of course, if you can save more than that, having a fund outside the Roth to draw on first makes sense, since the best Roths are those that leave contributions in for several decades to compound without further IRS invasion.
- Earnings, unlike contributions, cannot be withdrawn tax-free until five calendar years have passed since the first contribution to the Roth and the taxpayer has reached the beginning of the calendar year in which he or she turns 59 1/2. So if you start a Roth in 2014, you cannot remove earnings on a tax-free basis until January 1, 2019 and only then if you hit 59 1/2 by the end of 2019. If you remove earnings before the five-year & 59 1/2 milestones are both reached, the earnings are taxed and the IRS adds a 10% penalty (and your state government might add even more taxes and penalties).
- The benefits of tax-free growth are so great, however, that you should do everything possible to delay withdrawals of any kind from your Roth until you’ve exhausted all other sources of funds. Indeed, it makes the ideal inheritance for your kids, since the earnings continue to grow tax-free for them until withdrawal. They will have to begin withdrawals immediately after your death but, unlike traditional IRAs, you don’t need to begin withdrawals in your own lifetime, even after turning 70 1/2.
- If you are a high earner in a high tax bracket, you should prefer to make tax-deductible contributions now. Indeed, you might not even have the option of a Roth if your total income is above the limits cited above. But even if you have that option, you’ll do better to take the big deduction benefit now and pay the taxes when you’re in a lower bracket — which leads to the next point.
- You can do a Roth conversion of amounts in a traditional IRA at any time. You’ll pay taxes, but no penalty, on the conversion, and after five calendar years the converted amount is treated like other contributions, fully removable and free of either taxes or penalty. (You can’t remove a converted amount immediately after the conversion since that would effectively be a way to get around the 59 1/2 rule for traditional IRAs.) The obvious time to do such a conversion is when you are in a low bracket, either because of a bad income year, perhaps related to unemployment, or retirement itself. Indeed, the first couple of years of retirement are a perfect time to do Roth conversions while deferring Social Security benefits until the optimal time to start them (which is often age 70).
- For the same reason, I am NOT a fan of the new Roth 401(k) plans for high-income taxpayers: a high-bracket deduction is better than tax exemption in a low-bracket year. You should only think about these if your tax bracket is going to low this year.
- If you are able to save more than your deductible employment-based plan contributions, but are not eligible for a Roth IRA due to high income, CONSIDER making a nondeductible contribution to a traditional IRA. You won’t get a deduction, and the earnings will only be tax-deferred, not tax-free. Worse than that, earnings will be subject to ordinary income tax rates upon withdrawal even though the typical investments of retirement money are equities generating favorable long-term capital-gains rates. So why consider them? Because in a subsequent low-income year, you could convert the traditional IRA to a Roth IRA, paying taxes only on the earnings at a presumably reduced rate; you will then have more in the Roth growing tax-free from that time forward. Of course, if you expect high-income years as far as you can see, the unfavorable taxation of accumulated earnings prior to the next low-income year might outweigh the benefit. Moreover, one of the great complications of tax life will be keeping track of accumulated nondeductible contributions to traditional IRAs so that you aren’t accidentally taxed a second time in the year of conversion. Even worse, conversions of nondeductible traditional IRA contributions are complicated by the presence of any deductible IRAs, since all conversions must be prorated based on the sum of all traditional IRAs. You know what? Forget what I said in this item: it is too big a pain-in-the-accounting for the benefit.
- Rather, forget what I said unless you currently have NO deductible IRAs, meaning no assets in traditional IRAs to which you previously made contributions or any rollover IRAs from previous employment. In that case, make the nondeductible contribution to your only, presumably empty, traditional IRA and then immediately convert everything from that traditional IRA into your Roth IRA at no tax cost and with no further complications. For all intents and purposes, you’ve made a normal Roth contribution even though your income presumably was too high to permit it. And you can do that every year, again with the major proviso that you have no other traditional or rollover IRAs with assets in them. If you’re not certain you can get away with this, ask your tax preparer.
Okay, this has gotten VERY long, so let’s put together the Twitter version:
- In high tax-bracket years, max out on tax-deductible retirement plan and traditional IRA contributions. You’re not eligible for the Roth IRA, and the Roth 401(k) isn’t a good choice in such a year.
- In moderate tax-bracket years, max out on the Roth IRA even at the expense of tax-deductible contributions, except to get the full benefit of any employer matching on company retirement-plan contributions. And if your employer offers a Roth 401(k) — this is a good time to consider it.
- In low tax-bracket years, do Roth conversions, paying a bit more in taxes now to get tax-free growth later. If you have any earned income, definitely max out on Roth IRAs and Roth 401(k) plans.
- Put high-growth investments in your Roth, and try to make them the last from which you draw in retirement, even though the rules make it easy to draw from them first.
Aren’t you sorry you asked why? Roth: Just Do It!