Creating a tax-free stream of income is a powerful retirement tool. Here's the scoop on Roth IRAs and 401k's.
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 401k in 2006. 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 nest egg.
Roths turn traditional IRA and 401k 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.
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.
In 2014, 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 2014, the ability to contribute to a Roth phases out if your adjusted gross income is between $181,000 to $191,000 for joint filers and between $114,000 to $129,000 for single filers.
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.
Many companies have added a Roth option to their 401k 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 401k account.)
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 401k. 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 401k contributions. A Roth 401k is a good option if your earnings are too high to contribute to a Roth IRA.
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.
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 premium surcharges 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.
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 years. 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.
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