Most Americans lack adequate retirement savings. But opening a Roth IRA is one great way to help meet your retirement savings goals. But before opening this account, it’s important to understand what a Roth IRA is, how it differs from a traditional IRA, and how it may impact your taxes.
What is a Roth IRA?
When talking about retirement planning, investors can utilize multiple savings tools. Individual Retirement Accounts (IRAs) are one of the most popular retirement investment tools, as they allow individuals to save for retirement and potentially save on taxes. However, there are multiple types of IRAs, each with different rules and benefits, so it’s a good idea to understand your options before deciding.
A Roth IRA allows you to contribute after-tax money. This benefit means that your money can grow tax-free, and you can generally make tax and penalty-free withdrawals after the age of 59 1/2. The primary difference between a Roth IRA and a traditional IRA is when you invest. Unlike a Roth IRA, traditional IRAs allow you to make pre-tax contributions.
The benefits of a Roth IRA include the following:
- Contributing after-tax funds may be better for individuals who anticipate being in a higher tax bracket when withdrawals begin.
- The contributions grow tax-free.
- Withdrawals are penalty- and tax-free after five years, and the individual is at least 59 ½ years of age.
- No mandatory distributions.
- You can begin contributing at any age as long as you have a qualifying income.
- Passing a Roth IRA on to heirs allows them to make withdrawals that are also income-tax-free.
- You can contribute to a Roth IRA and an employer retirement account like a 401(k) or 403(b).
- You have until April of the following year to make contributions. For instance, the latest you can contribute for the tax year 2022 is April 2023.
- You can use Roth IRA invested funds as an emergency fund to pay off expenses, such as unexpected medical bills or a child’s education. By limiting what you take to contributions only and not earnings, you can avoid taxes and penalties. However, it’s only advisable to tap into these funds before retirement if absolutely necessary.
It’s also important to follow the rules required with a Roth IRA. For instance, the maximum contribution allowed for 2022 is $6,000 annually. The only exception is that those over 50 may contribute up to $7,000 annually. Additionally, eligibility is restricted to those with earned income below a specified threshold. For single filers, the contribution starts to reduce at $129,000 for the tax year 2022; this figure is $204,000 for joint filers. In 2023, the cap will be $138,000 for single filers and $218,000 for joint filers.
How Does a Roth IRA Impact my Taxes?
Getting tax-free income is the stuff of dreams for many individuals. And while funds withdrawn from a Roth IRA aren’t exactly tax-free, it’s about as close as you can get. With a traditional IRA, you get a tax break up-front when you invest but must pay taxes on all distributions from the account. A Roth IRA is the exact opposite. You save after-tax dollars with no immediate tax break but get tax-free retirement withdrawals.
Investors looking to start a Roth IRA can do it independently of their employers or use a company Roth option (if the employer offers it). Additionally, you can convert funds from a traditional IRA to a Roth IRA at any time to take advantage of tax-free earnings. You must pay taxes on the full amount converted to a Roth IRA in the year you convert it. This tax payment is the price you pay to be free of taxes when you start withdrawals. This option may make sense if you expect to be in a higher tax bracket in the future.
For some investors, small conversions over a number of years may lower your tax liability. However, before moving forward with a conversion, you will want to consider how it might trigger other taxes. The added taxable income reported in the year of the conversion could put you in a higher tax bracket, even if it’s just for the year. And this jump in income could trigger other one-time taxes, such as the investment income tax, also called the Medicare surtax.
As you can see, the implications of a Roth IRA on any individual’s or family’s unique tax situation can vary widely. For this reason, it’s always a good idea to talk with an investment advisor or CPA before making any investment decisions. For more information about Roth IRAs, contact Parker Business Consulting today!
Parker Business Consulting & Accounting, P.C. is a unique firm with more than a combined 75 years of experience in private industry, coupled with a strong background in public accounting. This combination enables us to provide valuable assistance based on direct experience with many of our clients’ same issues.