Understanding the Roth Rules: Tips and Strategies for Achieving Financial Security

Summary

The Roth Rules are an important set of rules governing Roth IRA accounts and retirement planning. These rules are tax-favorable for retirement funding and are advantageous for those individuals who want to save for retirement without having to pay taxes on the money they save.


To qualify for the Roth Rules, an individual must meet certain requirements outlined by the Internal Revenue Service (IRS). The most important requirement is that the individual must have a modified adjusted gross income below the specified amount in the current tax year.

In addition, the individual must meet the five-year holding period requirement, meaning they must hold their Roth IRA investments for at least five years before withdrawing any funds. Furthermore, the individual must be at least 59 and a half years old and must pay taxes on any withdrawals they make.

The benefits of the Roth Rules are numerous. First, earnings on Roth IRA accounts are tax-free. This means that individuals can keep more money in their accounts instead of paying taxes on the earnings. In addition, any contributions made to the account are not taxable, which allows individuals to have more money available for retirement.

The Roth Rules are an important component of retirement planning because they provide an additional tax-advantaged option for saving for retirement. Individuals who meet the requirements for the Roth Rules will be able to save more money for retirement without having to pay taxes on their investments or withdrawals. The money saved can then be used to create a comfortable retirement lifestyle.
 

Introduction

The Roth IRA was created in 1997 as part of the Taxpayer Relief Act of 1997. It is an individual retirement account (IRA) that provides tax-free growth and tax-free withdrawals for qualified retirees. When it first appeared, the Roth IRA held promise as a unique retirement savings vehicle with substantial benefits. It provided a way to save for retirement while avoiding the double taxation associated with traditional IRAs.
 

Qualifying for a Roth IRA

To be eligible to open a Roth IRA, you must meet certain requirements. First, you must have earned income equal to or greater than the amount you want to contribute. Second, the total amount of your contributions cannot exceed your earned income. Lastly, your Modified Adjusted Gross Income (MAGI) must meet the limits set by the IRS. In 2021, the MAGI limits for a traditional Roth IRA are $140,000 to $208,000 for married couples filing jointly, and $125,000 to $208,000 for single filers.
 

Contributing to a Roth IRA

Once you've opened a Roth IRA and are eligible to contribute to it, you can do so up to the IRS-mandated maximum. Contributions must be made in cash, and you have the option to contribute either pre-tax or post-tax funds. Any contributions made with pre-tax funds are taxed when they are withdrawn. Contributions made after taxes, however, are not taxed at all upon withdrawal.
 

Roth IRA Distributions & Withdrawals

In general, withdrawals from a Roth IRA are tax-free and penalty-free. However, there are some rules that must be followed in order to receive these exemptions. In order to make a tax-free withdrawal, the account must be five years old, and the withdrawal must be made after reaching the age of 59½. Distributions prior to age 59½, while not taxable, they may be subject to a 10% penalty.

The only exception: If your employer matches contributions to your work-sponsored plan, then it's probably best to take advantage of that free money. But contribute only up to the point that contributions are matched; after that, send your retirement money to a Roth.

The exception to the exception: In most situations, an employee has to stay with a company for a number of years before those matching contributions will "vest" — that is, really become the property of the employee. If you don't plan to stay with your employer long enough for the matches to vest, then go straight to the Roth.

What makes a Roth so superior? Let's start with the fundamentals.

Roth basics
The maximum that can be deposited in a Roth in 2005 is $4,000 ($4,500 for workers age 50 and older). Unfortunately, not everyone is eligible. Once your adjusted gross income reaches $95,000 if you're single or $150,000 if you're married, the amount you can contribute to a Roth begins to decrease, reaching zero for those with an AGI of $110,000 (singles) or $160,000 (married). So, if you're not eligible for a Roth, stick with your 401(k) and/or traditional IRA.

The major difference between a Roth and the other retirement accounts is when you get the tax break. Contributions to a deductible traditional IRA and to a 401(k) reduce your taxable income in the year the contribution is made, and that cuts your income tax bill.

These accounts are considered "tax-deferred" because you won't pay taxes on interest, dividends, or capital gains in the account during your working career. But when the money is withdrawn in retirement, it counts as ordinary income and will be taxed at the same rate as income earned from a job (i.e., not at the lower long-term capital gains rate).

With a Roth, contributions do not reduce taxable income, so there's no deduction. However, the Roth is a tax-free account; no taxes are paid on the interest, dividends, or gains — ever.

Pay taxes now or later?
So, the question is, do you want to cut your tax bill now or in retirement? All kinds of calculators can theoretically indicate which account will provide more in retirement. (We have several Roth IRA calculators at Fool.com.) The conventional wisdom is that if your tax bracket now is higher than your bracket will be in retirement, a deductible account might be the better bet.

However, the problem with calculators and similar analyses of the Roth vs. traditional IRA/401(k) dilemma is they assume that any tax savings realized from contributing to a deductible account will be invested elsewhere and left alone for retirement. However, this just isn't a realistic assumption. People don't say to themselves, "Well, my tax bill is $800 less because I contributed to my 401(k), so I'll buy 32 shares of Microsoft (Nasdaq: MSFT) and not touch it until I'm 65."

No, that tax savings usually goes somewhere else — and usually not to any type of savings account. Boiled down to the essentials, you're contributing to a retirement account to make your golden years more affordable, not to give yourself a tax break today (as great as that can be). And the retirement account that will require you to pay less to Uncle Sam after you've stopped working — thus leaving more in your bank account — is a Roth IRA.

Put another way, do you want the heavier tax burden now, while you're still earning a paycheck and can cover the liability, or when you've stopped working and can't make up for anything Uncle Sam takes away? To me, the best strategy is to choose the account that will improve your finances in retirement.

Finally, the more taxable income you receive in retirement, the more likely your Social Security benefits will also be taxed. Income from a Roth IRA, however, does not affect the calculation of whether you'll pay taxes on a portion of your retirement benefit check.

No required distributions
As mentioned earlier, employer-sponsored retirement accounts and traditional IRAs are tax-deferred — you'll have to pay taxes on the money at some point. And Uncle Sam doesn't want to wait forever, so he came up with something called minimum required distributions (MRDs). According to the rules, you must begin taking money out of your 401(k) or traditional IRA by April 1 of the year following the year in which you reach age 70 1/2 — whether you need the money or not. (If you're still working, you can delay MRDs in your 401(k) until after you retire.)

However, since Uncle Sam doesn't have a vested interest in the tax-free money in Roth IRAs, they aren't subject to MRD rules. So, if you can live on your Social Security, pension, other savings, and perhaps part-time work, then the money in your Roth can keep growing tax-free, creating a bigger bundle for when you do need it.

A Roth IRA is also good for the beneficiaries of your estate. Just as you would receive the proceeds of a Roth tax-free, so would your heirs. However, beneficiaries have to pay income taxes on the money inherited from 401(k)s and traditional IRAs. (Both forms are still subject to estate taxes, if applicable.)

Getting your hands on the money
We just talked about how the Roth is better if you don't need the money by the time you're 70 1/2. But what if you want the money before you're 59 1/2? Again, the Roth is the winner.

Withdrawals from an employer-sponsored retirement plan or a traditional IRA before the age of 59 1/2 can lead to taxes and penalties, except under special circumstances. This is not necessarily true for a Roth.

Contributions to a Roth — that is, the money you send to the custodian of the account — can be withdrawn at any time, penalty- and tax-free. For example, let's say you contribute $4,000 to a Roth this year, and in three years, it grows to $5,000. You can withdraw your four-grand contribution at any time, no questions asked. However, if you try to take out that $1,000 in growth before you're 59 1/2 and the account has not been open for five years, then you may be subject to taxes and penalties (again, except in special cases).

So, if you plan to retire early, the Roth is a great place for your money because you can start withdrawing the money before age 59 1/2 without a hassle. Some experts suggest that this also makes the Roth a good account for college savings, emergency savings, and other goals. Believe it or not, those arguments have merit, but it's a complicated discussion — a topic for a future article. Until then, consider opening a Roth (you still have until April 15 to open an account for 2004), and take a free 30-day trial to The Motley Fool's Rule Your Retirement newsletter service.



Robert Brokamp practices what he preaches: He contributes to his 401(k) enough to get the full match, then contributes to a Roth, and then feeds his children if anything's left over. The Motley Fool is investors writing for investors.

This feature may not be reproduced or distributed electronically, in print or otherwise without the written permission of uclick and Universal Press Syndicate.