The Roth IRA was created by the Taxpayer Relief Act of 1997. The Roth IRA allows an individual to save for retirement with after-tax dollars with the expectation of tax-free withdrawals during retirement. While most IRA contributions are still made to traditional IRA accounts, Roth IRA participation has increased steadily since 1997. In recent years, Congress has also helped to establish the Roth 401(k) account. Not all employers provide for the Roth 401(k), but more are offering this choice each year.
The traditional IRA has been a popular choice for Americans to save for retirement as well as reducing their tax liability. Earnings from a traditional IRA grow tax-deferred until distribution. A contribution to a traditional IRA may also be fully or partially deductible from income taxes if it falls below a phase out limit.
In tax year 2012, the income phase-out for traditional IRA was $58,000-$60,000 for a single tax filer or $92,000-$112,000 for joint filers if the filer was active in an employer sponsored retirement plan (such as a 401(k), 403(b), etc.). For a spouse who is not active in an employer-sponsored retirement plan, but their spouse is an active participant, the phase-out limit is $173,000-$183,000. The 2012 limit on contributions for a traditional IRA is $5,000 or $6,000 for those ages 50 and over. The 2012 contribution figures are used here because taxpayers have until April 15 to make a contribution to an IRA for tax year 2012. This may be an excellent way to reduce your tax liability for 2012 while saving for retirement. Keep in mind that if you exceed the phase-out income limits you can still make a contribution to a traditional IRA. However, you would not be able use it as a tax deduction. The future earnings would still grow tax-deferred.
The Roth IRA differs from the traditional IRA in several ways. You cannot deduct (for tax purposes) contributions to a Roth IRA. However, where qualified withdrawals from a traditional IRA will be taxed at you current tax rate, the Roth IRA withdrawals will be tax-free. With the Roth IRA, you pay your taxes upfront and withdraw tax-free. With the traditional IRA you usually make contributions tax-deferred and make withdrawals taxed at your current rate. Another difference between the two IRA plans is that the traditional IRA will require you to make required minimum distributions (RMDs) starting at age 70½. You will be required to take a withdrawal from your IRA each year. A life expectancy table is used to calculate your yearly RMD.
The Roth IRA requires no RMD. You never have to withdraw the funds and you can leave the balance to your beneficiaries tax free (once the account is open for five years). As a matter of fact, in order to make qualified withdrawals from a Roth IRA, the account must be opened for five years. The account is considered opened on Jan. 1 in the year that the account was opened. You can also contribute to a Roth IRA after you are age 70½, unlike a traditional IRA. The 2012 Roth IRA phase out limits are $112,000-$125,000 for single filers and $173,000-$183,000 for joint filers. The 2012 annual contribution limit to the Roth IRA is $5,000 or $6,000 if you are age 50 and over.
The following individuals are usually good candidates for a Roth IRA: young person in a lower tax bracket, anyone expecting tax rates to increase, anyone who wants to shelter earnings after age 70½, individuals saving for a first home or Individuals wanting to pass on assets tax-free to their beneficiaries.
The more recent creation of the Roth 401(k) has several more twists when compared to the Roth IRA. The 2012 contribution limit for the Roth 401(k) is $17,500 for an individual and an additional $5,500 if you are age 50 and over. There is also no phase-out income limit for contributions to the Roth 401(k). Therefore, an individual making more than $183,000 in 2012 can still contribute to the Roth 401(k).
A disadvantage to the Roth 401(k) is that this account does have RMDs similar to a traditional IRA. It also has its own five-year clock. Therefore, if you had both a Roth 401(k) and Roth IRA you would need to pay attention to both five-year clocks before making withdrawals.
Now that I have provided you with more information on these individual retirement plans than you probably want to know, let's discuss some creative methods to make the best use of some unique situations.
For those individuals who have access to and do take advantage of the Roth 401(k), the combination of a Roth IRA may be very beneficial. In addition to the Roth 401(k), these individuals should consider opening a Roth IRA at least five years before their planned retirement. The amount to open the Roth IRA is of no consequence. This will start the five-year clock on the Roth IRA, which will allow for qualified withdrawals when retirement begins. Nonqualified withdrawals may be subject to a 10 percent penalty. Once the individual opens the Roth IRA they should then consider rolling the Roth 401(k) into the Roth IRA upon retirement. This will allow for greater flexibility and opportunities with investments. The Roth IRA is also not subject to the RMD. The funds that are transferred to the Roth IRA will fall under the five-year clock of the Roth IRA (not the Roth 401(k)). Therefore, it is important to have the Roth IRA opened five years before retirement. By following this path, an individual can contribute at a high level to the Roth 401(k) while employed, and then enjoy the flexibility of the Roth IRA upon retirement.
The rules and regulations concerning IRAs are vastly more expansive than what has been discussed in this article. Therefore, I recommend that you consider all comprehensive retirement planning with your financial planner and accountant.
HERMAN KRUG is an accredited asset management specialist designee with Stourbridge Capital Partners LLC, an independent investment adviser, in Honesdale. He can be reached at hkrug@stourbridgecapital.com.