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The Raffer Investment Group

All About Roth Accounts

What is a Roth IRA or 401k Account

By Jeremy Raffer

 

In order to make the most out of this subject, I’d recommend you first brush up on the differences between a 401(k) and an IRA.

 

Roth IRA or 401k

 

While researching 401(k)s or IRAs, you may have heard the word Roth being tossed around. The Roth is a retirement account type that consists of different tax rules for your assets. With Roth accounts the money is taxed before being deposited into the investment account. This is opposite to traditional retirement accounts like the 401(k) or IRA where the money goes in pre-tax--providing you with a tax deduction. Luckily no matter which of the accounts you choose, the money grows sans tax. The difference with the Roth though is that when it’s time to take your distributions in retirement, the money comes out tax-free (after the age of 59 1/2). So let’s learn more about what this means for you and what to consider before setting one up.

 

Table of Contents:

The Two Types of Roth Accounts

So Why Give Up The Tax Deduction?

Phase-out Limits

Back Door Roth

Rollover Benefits

Summary

 

 

The Two Types of Roth Accounts - IRA and 401k

There are two types of Roth accounts--the Roth 401(k) and Roth IRA. Just like with a traditional 401(k) and IRA, the Roth 401(k) allows significantly higher contributions than a Roth IRA. As of 2018, Roth 401(k)s permit you to contribute $18,500, with an additional $6,000 if you’re over the age of 50. Comparatively, as of 2018 the Roth IRA only permits contributions of $5,500, with an additional “catch up contribution” of $1,000 if you’re over age 50. Throughout this article I’ll be referring to Roths in a general manner with regard to the tax treatment of the account, but keep in mind you can choose specifically between a Roth 401(k) or Roth IRA for the above reasons.

 

Roth IRA

 

So Why Give Up The Tax Deduction with a Roth?

Now you may be trying to figure out why you would want to give up the initial tax deduction and choose a Roth. If you choose a 401(k) or Traditional IRA, you would have more money initially in your pocket. But think of it this way; which would you rather pay tax on--the small original contribution or the larger possibility of what that could grow into? The big pile of money at the end of the road is where you want to minimize your taxes the most. A Roth type account accomplishes this, and the longer you have between your investment and when you plan to withdraw the money, the greater the benefit because it has more time to compound and grow. Consequently, as you get older and thus closer to the time where you will be withdrawing from the account, this benefit is smaller. That’s not to say it’s a bad idea; the benefits just become progressively reduced and you need to do some math to figure out if its worth it.

 

Taxes

 

Phase-out Limits

Phase-out limits are a primary difference between the Roth and non-Roth account types. A phase-out limit is the gradual reduction of your ability to participate as your income grows; if your income is too high, you won’t be eligible. The government has drawn their line in the sand for this limit at $120,000 for an individual and $189,000 if you’re married. If you go above these numbers, you can no longer contribute directly into a Roth IRA.  My use of the word directly might be confusing, I'll explain later on. 

Also, it's important to know that Roth 401(k)s do not have income phase outs.  There are political explanations for this that are beyond the purview of this blog post. Call me up and I'll talk your ear off about it.  Just know that if you make a great income the Roth 401(k) is still an option.

 

Back-Door Roth

So what do you do if your income exceeds the phase-out limits and you don’t have a Roth 401(k) at your disposal (not all employers offer one)?  You make your contribution into a Traditional IRA, because of your highly compensated status you can’t contribute directly into a Roth IRA. Remember what I'd said earlier about directly? You are legally permitted to convert assets in a Traditional IRA account into a Roth IRA or roll the balance into the one you already have.  This is called a "Back-Door" Roth contribution.

What many people do is make an IRA contribution every year and then roll it into their Roth--thus enjoying the benefits of the Roth despite the income restrictions. I’m sure there’s some politics as to why this is still allowed--because it’s an obvious loophole in the system--but nevertheless people have been doing it for a while and it's hardly a secret. 

 

Rollover Benefits for a Roth

Another benefit of the Roth is that unlike traditional IRAs and 401ks, you are not required to remove your money once you’ve reached "retirement age". Specifically, at the age of 70 1/2 is when a traditional IRA requires you to take an RMD (required minimum distribution). This minimum distribution starts out at roughly 3.5% of the balance of the account at that age and goes up each year as you get older.

 

The implications of this are huge because it turns the Roth IRA into a great tool to transition wealth over to the next generation, since it can grow tax-free all the way up to the owner's death. In fact, it can continue to grow tax-free with no required distributions until the death of the surviving spouse. So, if a husband has a Roth and predeceases his wife, she would inherit it and it would continue to grow without her having to take a penny. The only instance when distributions are required on a Roth account are when someone other than a spouse inherits it, like a child.  

 

Roth 401k

 

Summary

There are so many options to choose from when retiring and all the different account types can feel very overwhelming. Understanding the differences between your options can help you choose an investment plan and strategy that best aligns with your personal goals and philosophy. When considering Roth accounts, just remember, the money is taxed going in not when coming out.  It’s also important to know the phase-out limits of the current year, and to plan for the long term.  Which type of retirement savings strategy do you use? Let us know in the comments below.

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Jeremy Raffer, MBA
Wealth Manager
 
Phone – 201-773-4641
 

 

Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation.  While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation.  Any opinions are those of Jeremy Raffer and not necessarily those of Raymond James.