If you don’t have a Roth IRA, you probably should. Roth IRAs are great planning tools. They can be used to save for retirement, save for college (bet you didn’t know that one) and convert traditional IRA assets.
What is a Roth IRA?
I’m sure most of you have heard of Roth IRAs and are at least somewhat familiar with the benefits of such an account. Here’s a brief overview: a Roth IRA is a retirement account funded with after-tax income, and if the rules of a Roth account are followed, and the account is qualified, the earnings generated from the account can be withdrawn income tax free when it comes time for distribution. Thus, the longer the money is compounding in the Roth, the more advantageous it becomes.
Roth IRA vs. Traditional IRA
If you were a farmer, would you rather take some short-term pain and pay taxes on the seeds you buy, knowing that your harvest would be tax-free? I hope most of us would take the short-term pain to reap the larger reward (less total dollar amounts paid in taxes) when it comes time to harvest. This is one of the best analogies I’ve heard for a comparison between a Roth IRA and a Traditional IRA. Now it’s not completely apples-to-apples because you must consider tax rates and timing when deciding between a Roth or traditional IRA, but it’s mostly accurate.
Roth IRA Rules
And of course, any account that comes with certain advantages, also comes with certain rules.
$6,000 limit, plus $1,000 catch up if over age 50 ($7,000 total)
These contributions are phased out for taxpayers with modified adjusted gross incomes (MAGI) of:
- $122,000-137,000 for single taxpayers
- $194,000-203,000 for married filing jointly
Required Minimum Distributions (RMDs) do not apply with Roth IRAs, and you can contribute past the age of 70.5
Roth IRA Distribution Rules for 2019
Since contributions are after tax, they will not be taxed again and can be withdrawn tax and penalty free regardless of when they are contributed.
For all account money (contributions and earnings) to be qualified, the account must be open at least 5 years and one of the following:
- Owner's age is 59 ½
- Owner dies
- Owner becomes disabled
- Payment is made on a first-time home with a $10,000 lifetime cap
* It is not possible for a Roth to be qualified if the five-year holding period is not met
* If you are over 59 ½ and have not met the five-year holding requirement, your earnings (not contributions) will be subject to taxes but not penalties.
Roth IRAs for College Savings
Roth IRAs for college savings: A lesser-known benefit of Roth IRAs where they show, yet again, how they can be used as great planning tools.
When considering a Roth IRA account for college savings, the first thing to consider is how old you will be when your child is in college. If you will be 59 ½ or older, (and you’ve met the five-year holding requirement), you can use your Roth dollars to pay for anything, including college, with no tax implications or penalties.
Now, if you will be younger than 59½ when your child is in college, you can still use Roth money for college expenses, but your withdrawal will not be qualified. How can you do this and pay no taxes or penalties? Well, only the earnings portion of your distribution would be taxable, not the contribution portion.
The idea is to withdrawal the contribution portion of your Roth dollars and leave the earnings portion, so you pay no income tax. Non-qualified withdrawals from a Roth IRA take contributions first and then earnings, so you could theoretically withdraw up to the amount of your contributions and not owe income tax.
The key to this strategy is that the 10% early withdrawal penalty that normally applies to withdrawals before age 59½ is waived if you use Roth dollars to pay for college. So, if you use Roth dollars to pay for college expenses and you’ll be younger than 59½ when your child is in college, you might owe income tax (only on the earnings portion of the withdrawal), but you won’t owe a penalty.
One last perk is that retirement assets aren’t counted by the federal or college financial aid formulas. Therefore, your Roth account balances won’t affect financial aid.
*As always, be sure to consult your tax consultant or financial planner before implementing any changes. But the flexibility and benefits of a Roth IRA account should not be overlooked with almost any plan.