Things You Must Know About Roth Accounts
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.3.
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 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.
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 IRA.
5.You Can Do a Roth Conversion
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 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.
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.
8.There Are Two Five-Year Rules
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.
9. There's an Order to Withdrawals
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 for college savings.
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 investment income.
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 15, 2014.
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.
11. A Roth Can Benefit Heirs
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 expectancy. 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.