and its Many Uses
Many investors are familiar with Roth IRAs. They’re a great way to save after-tax money for future use. The main benefits are this: your money grows tax free and can be taken out tax free after age 59 1/2. (An added bonus is that contributions can often be taken out tax- and penalty-free before then). The main drawdowns are the annual contribution limits (currently $5,500 or $6,500 if you’re 50 or older) and that if you make too much money (a great problem to have) then you’re not eligible to contribute to a Roth IRA. For many who fit into this category, that means you’ve long since pushed these accounts out of your mind as they simply don’t apply to you.
Not so fast. You may be missing out. Roth IRAs have the flexibility to be useful in several different scenarios. Here are my favorite three:
1. Retirement Savings (The Standard Use)
You’re just starting out and want to save more for the future. Maybe your company has a workplace retirement plan, but the investment options aren’t great and the fees are high. Once you’ve contributed enough to get the match (do that first!), a Roth IRA is a great way to supplement your retirement savings. If you don’t have access to a workplace retirement plan, the Roth is usually a great place to start. As has been already mentioned, though, there are income limitations. In 2017 individuals making over $133,000 and couples making over $196,000 can’t contribute to Roth IRAs in their own name.
2. Education Savings (A Creative Use)
A retirement account for education? It can make sense. If your child has earned income, she (or you) can contribute up to the amount of her earned income each year into a Roth IRA. Those contributions can come out tax- and penalty-free for qualified education expenses. The main benefit of this is that the money is there if your child needs it for school, but if it ends up not being needed then he or she’s already ahead of the game when it comes to retirement savings. Distributions can also be made from a parent’s Roth IRA for qualified education expenses, and this may make sense so long as it doesn’t deplete needed retirement savings. If you’ve already funded a 529 college savings plan, or aren’t sure whether education funds may be needed, the Roth IRA can help you strike a good savings balance.
3. Tax and Estate Planning for Higher Net Worth Individuals (Becoming More Popular, and for Good Reason)
Those with higher incomes aren’t able to contribute to a Roth IRA, but that doesn’t mean they can’t use them. Enter what’s called a Roth IRA conversion, sometimes referred to as a back-door Roth IRA contribution. If you have monies in a qualified tax-deferred retirement account such as a traditional IRA, you can convert all or a portion of that account to a Roth IRA. This can occur incrementally, over a period of years, through multiple conversions. You’ll pay income taxes on the amount converted, but not penalties. The benefit of this would be for those with large balances in tax-deferred accounts who will not need the income generated after age 70 1/2 when required minimum distributions begin. This has the ability of lessening the future tax burden both for the retiree and for their heirs, as inherited Roth IRA distributions aren’t subject to the same income tax liability as distributions from inherited traditional IRAs. If timed appropriately, conversions can take place in early retirement years when taxable income (and thus your tax bracket) is lower. Roth IRA conversions aren’t without risk, though, and require careful tax planning to ensure the amount converted in any given year doesn’t unnecessarily raise that year’s income tax rate. This is a strategy best planned out in consultation with your tax preparer and financial advisor.
In Summary
On the surface, a Roth IRA is one of many ways we can save for retirement, but with a lot of catches. To the informed investor, however, the Roth IRA’s flexibility lends itself to multiple productive uses. Not only is this account a great tool for retirement savings, but it can also be useful when planning for education expenses, your tax burden in retirement, and estate planning. Sometimes, it pays to look beneath the surface.
Disclaimer: This article is generalized in nature and should not be considered personalized financial, legal, or tax advice. All information and ideas provided should be discussed in detail with an advisor, accountant or legal counsel prior to implementation.
