Protect your savings from taxes. Investing in a Roth won’t reduce next year’s tax bill because Roths are funded with after-tax dollars. The payoff comes later. Once you’re 59 1/2 and have owned the Roth for at least five years, withdrawals are tax- and penalty-free. That’s not the case with traditional IRAs and 401(k) plans. Investing in those accounts will lower your tax bill in the year of the contribution, but future withdrawals will be taxed at ordinary income tax rates, which currently range from 10% to 39.6%.
That makes Roths particularly attractive for young workers. If you’re just starting out, you’re probably in a low tax bracket, which makes the upfront tax savings of a deductible IRA less valuable. A Roth, however, promises decades of tax-free earnings growth. And if you find yourself in a much higher income tax bracket when you retire, your tax-free withdrawals will be all the more valuable.
In 2013, you can contribute up to $5,500 to a Roth IRA (or $6,500 if you’re 50 or older). You may invest in both a Roth IRA and a 401(k) plan. And if you can afford to do both, you should (but above all, be sure to take advantage of any employer matches for 401(k) contributions). Holly and Greg Johnson, who live outside Indian­apolis and blog about their finances at www.clubthrifty.com. opened Roth IRAs a couple of years ago to supplement their 401(k) plans. “We wanted to save more, and we wanted to do it in a tax-diversified way,” Holly says.
If you withdraw earnings from your Roth before age 59 1/2, you’ll usually pay taxes on that money, along with a 10% penalty. But there’s an exception for first-time home buyers. If you’ve owned the Roth for at least five years, you may withdraw up to $10,000 in earnings for the purchase of a home without paying taxes or penalties. Plus, your contributions come out tax- and penalty-free even before you begin to tap into earnings.
If you tap your Roth to pay for a child’s college costs, you’ll owe taxes if you dip into earnings, but you’ll be spared the 10% early-withdrawal penalty. “As an all-purpose starter savings vehicle, it’s hard to beat,” says Christine Benz, director of personal finance for Morningstar.
What’s the catch? Unfortunately, people who can afford to leave money to their children are often ineligible to contribute to a Roth. In 2013, married couples who file jointly can contribute the maximum to a Roth if their modified adjusted gross income is less than $178,000. Those with MAGI of up to $188,000 can contribute a reduced amount; those with MAGI of $188,000 and above are disqualified. Single taxpayers with MAGI of up to $112,000 can contribute the maximum; those with MAGI up to $127,000 can contribute a reduced amount, and those with $127,000 and above are ineligible.
There’s a way around this problem, but it’s complex and requires considerable planning. The law allows anyone, regardless of income, to convert a traditional IRA to a Roth. The catch is that you must pay taxes on all pretax contributions and earnings. If you have enough money to live on in retirement and intend to leave the IRA to your kids, a conversion may be worth the cost (especially because the tax bill you pay will reduce the size of your taxable estate). But if you plan to withdraw the money for retirement expenses in 15 years or less, you’ll have less time to benefit from tax-free earnings growth and the savings from tax-free withdrawals may not be sufficient to offset the tax you’ll pay on the conversion, Benz says. Be aware, too, that because an IRA conversion would increase your taxable income, it could affect everything from eligibility for college financial aid to taxes on your Social Security benefits.
Some high-income investors have gotten around contribution limits through what’s known as a “back door” Roth IRA. With this strategy, you contribute to a nondeductible IRA using after-tax dollars, then convert that IRA to a Roth. As long as you act before any earnings accumulate, you won’t owe tax on the conversion—unless, that is, you also have one or more other traditional IRAs. In that case, your tax bill on the conversion will be based on the percentage of taxable and tax-free assets in all of your IRAs. If you rolled over a former employer’s 401(k) to an IRA years ago, Benz says, a conversion could trigger an unexpected tax bill.
Suppose you contribute $5,000 to a nondeductible IRA, then immediately convert it to a Roth. And let’s say you also have another traditional IRA that holds $95,000 from contributions, a 401(k) rollover and earnings. Because the nondeductible contribution represents just 5% of the new total of $100,000, only 5%, or $250, of the $5,000 conversion will be tax-free.