10 Things You Must Know About Roth Accounts
Tax-free income is a dream of every taxpayer. And if you save
in a Roth account, it's a reality. Roths are the youngsters of
the retirement savings world. The Roth IRA, named after the late
Delaware Sen. William Roth, became a savings option in 1998,
followed by the Roth 401(k) in 2006. Creating a tax-free stream
of income is a powerful retirement tool.
These accounts offer big benefits, but the rules for
Roths can be complex.
Here are ten things you must know about adding a Roth to your
You Pay Uncle Sam Now Instead of Later
Roths turn traditional IRA and 401(k) rules on their head.
Rather than getting a tax break for money when it goes into the
account and paying tax on all distributions,
with a Roth, you save after-tax dollars and
get tax-free withdrawals in retirement
By accepting the tax breaks for traditional accounts, you
accept the government as your partner. If you're in the 25% tax
bracket, for example, 25% of all earnings will effectively belong
to the IRS to be collected when you withdraw the money. With a
Roth, 100% of all future earnings are yours.
The Roth strategy of paying taxes sooner rather than later
will pay off particularly well if you're in a higher tax bracket
when you withdraw the money than when you passed up the tax break
offered by the traditional account. If you're in a lower tax
bracket, though, the Roth advantage will be undermined.
There Are Limits to Contributing to a Roth IRA
To be able to contribute to a Roth, you must have earned
income. And unlike traditional IRAs, if you're still working
after age 70 1/2, you can keep contributing.
you can stash up to $5,500 in a Roth IRA and an extra
$1,000 if you're 50 or older
But higher-income taxpayers are barred from contributing to a
Roth IRA. For 2013, the ability to contribute to a Roth phases
out if your adjusted gross income is between $178,000 and
$188,000 for joint filers and between $112,000 and $127,000 for
single filers. Those thresholds go up for 2014: $181,000 to
$191,000 for joint filers and $114,000 to $129,000 for single
You can make a 2013 Roth IRA contribution as late as April 15,
2014. You can contribute to both Roth and traditional IRAs, but
the total cannot exceed the annual limit.
Your Company May Offer a Roth Option
Many companies have added a
to their 401(k) plans. After-tax money goes into the Roth, so you
won't see the immediate tax savings you get from contributing
pretax money to a traditional plan. But your money will grow
tax-free. (Any employer match will go into a traditional 401(k)
For 2013 and 2014,
you can stash up to $17,500 a year, plus an extra $5,500
a year if you're 50 or older, into a 401(k)
. Contributions must be made by December 31 to count for the
current tax year, and the limit applies to the total of your
traditional and Roth 401(k) contributions. A Roth 401(k) is a
good option if your earnings are too high to contribute to a Roth
You Can Do a Roth Conversion
Another route to tax-free earnings inside a Roth is to convert
traditional IRA money to a Roth. In the year you convert, you
must pay tax on the full amount shifted into the Roth. That's the
price you pay to buy tax freedom for future earnings. (If you
have made nondeductible contributions to your traditional IRA, a
portion of your conversion will be tax-free.)
If you expect your tax rate to be the same or higher in
the future, converting could make sense; if you expect your
future tax rate to be lower, it might not.
You'll want to pay the tax owed on a conversion with money
outside of the IRA. Drawing money from the IRA to pay the tax
will result in an additional tax bill, and a penalty if you're
under age 59 1/2.
A Conversion Could Trigger Other Tax Events
Look at the big picture if you plan a conversion. The added
taxable income could boost you into a higher tax bracket. A big
jump in income could trigger other taxes, too, such as the
new 3.8% surtax
on net investment income. For Medicare beneficiaries, a rise in
adjusted gross income could result in
for Part B and Part D.
A series of small conversions over several years could keep
the tax bill in check. For instance, you may want to
convert just enough to take you to the top of your
current tax bracket.
You Must Pass the Tests for Tax-Free Earnings
Because there's no tax deduction for Roth contributions, you
can retrieve that money at any time free of taxes and penalties,
regardless of age.
But for earnings to be tax- and penalty-free, you have to pass
a couple of tests. First,
you must be 59 1/2 or older
. You will get hit with a 10% early-withdrawal penalty and taxes
if you take out earnings before you hit age 59 1/2. And
you must have had one Roth open for at least five
. If you are 58 and opening your first Roth IRA in 2013, you can
tap earnings penalty-free at age 59 1/2, but you won't be able to
tap earnings tax-free until 2018.
There's a different rule for conversions. Read on.
There Are Two Five-Year Rules
If you make a conversion,
you must wait five years or until you reach age 59 1/2,
whichever comes first, before you can withdraw the converted
amount free of the 10% penalty
. Each conversion has its own five-year holding period. So if a
young account owner does one conversion in 2013 and a second
conversion in 2014, the amount from the first conversion can be
withdrawn penalty-free starting in 2018 and the amount from the
second starting in 2019.
Earnings on a converted amount can be withdrawn tax- and
penalty-free after the owner reaches age 59 1/2, as long as he or
she has had any Roth IRA opened at least five years.
There's an Order to Withdrawals
The rules for determining the source of money coming out
of a Roth work in the taxpayer's favor.
The first money out is considered contributed amounts, so it's
tax- and penalty-free. Once contributions are depleted, you dip
into converted amounts (if any). This money is tax- and
penalty-free for owners 59 1/2 and older or younger ones who have
had the converted amount in a Roth for more than five years. Only
after you have cashed out all converted amounts do you get to the
earnings. Once the account owner is 59 1/2 and has had one Roth
for at least five years, earnings, too, can be withdrawn tax- and
The ability to tap money in a Roth IRA without penalty before
age 59 1/2 allows for flexibility to use the Roth IRA for other
purposes. For example, the account could be used as a fallback
Once you reach retirement, having a pot of tax-free income to
draw upon may allow you to lower your tax bill. Roth money
doesn't count in the calculation for taxing Social Security
benefits, for example, or in the calculation for the new tax on
You Can Take a Mulligan
Roth IRA conversions come with an escape hatch. If you
converted $50,000 but the Roth is now worth $35,000, you would
still owe tax on the $50,000.
Undoing the conversion--known as a
recharacterization--wipes away the tax bill.
Recharacterizing can also pay off if you can't afford the tax
bill or the conversion unexpectedly pushes you into a higher tax
You have until October 15 of the following year
to undo a conversion
. So a 2013 Roth IRA conversion can be reversed up until October
But note: While you can now convert a traditional 401(k) to a
Roth 401(k) within a company plan,
an in-plan conversion cannot be reversed
A Roth Can Benefit Heirs
Unlike traditional IRAs--which you must begin to tap at age 70
1/2--Roth IRAs have no minimum distribution requirements for the
original owner. So, if you don't need the money, it can grow in
the tax shelter until your death. If your spouse inherits the
account, he or she never has to make withdrawals, either.
If the Roth IRA passes to a nonspouse heir, the rules change.
They are required to take minimum distributions starting the year
following the death of the original owner, or empty the account
within five years of the account owner's death. Distributions,
though, will still be tax-free and can be
stretched over the beneficiary's life
A young child or grandchild who inherits a Roth has the
potential for decades of tax-free growth.
Wealthy taxpayers may find another estate-planning advantage
to a Roth conversion. The taxes paid on a Roth conversion will be
removed from their taxable estate.
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