Because this is the time of year people are having their taxes done, I get a lot of questions about Roth IRAs.
Investing in a Roth IRA can be another powerful tool to avoid income taxes on its growth. To fully understand the costs and benefits of investing in a Roth IRA, you need to know how they differ from traditional IRAs.
Here’s the main difference. When you earn income and invest it into a traditional IRA, you don’t currently pay taxes on that income. However, when you withdraw money from the traditional IRA, you will incur income taxes on the full amount that you withdraw.
Conversely, when you earn income and invest it into a Roth IRA, you are still required to pay taxes on that income.
On the other hand, when you take money out of the Roth IRA, you generally do not incur any income taxes on that amount.
Simply put, traditional IRAs grow tax deferred while Roth IRAs grow tax-free. How does this affect your investment?
Here’s an example – John earns $50,000 in 2013 before taxes. As the year winds down, his employer decides to give John a $5,000 bonus due to his exceptional work. John decides he wants to save this money for retirement. Let’s assume he narrows his choices down to either contributing to a traditional or Roth IRA.
If he invests in a traditional IRA, the $5,000 bonus is essentially untaxed for now, so he can invest the full $5,000 into the IRA. Conversely, if he invests in a Roth IRA, the $5,000 bonus will currently be taxable income. John is in the 25 percent tax bracket for 2013, so he will incur a $1,250 tax bill on his bonus. He’s left with $3,750 to invest in the Roth.
Now, let’s assume that both IRAs invest in the same exact investments, which grow at about a 7.2 percent rate, roughly doubling every 10 years. In 20 years, the $5,000 invested in the traditional IRA grows to $20,000, but will be subject to tax when distributed. (i.e. it’s tax deferred). Assuming John remains in the 25 percent tax bracket, this $20,000 is subject to a $5,000 tax, resulting in a net $15,000 upon its distribution.
What about the Roth IRA? The $3,750 invested would grow to $15,000, and upon its distribution John would receive the full $15,000 income tax-free.
As you can see, there is no difference in these two options. However, if you expect your interest rates to be higher when you decide to withdraw your money from the IRA, Roths begin to look more appealing.
Why would your interest rates increase? The two primary reasons are:
1. You are earning more income in the year you withdraw the money, and are therefore subject to a higher income tax bracket.
2. The federal government raises your tax rates.
For example, assume the same facts as above. However, assume also that in 20 years, Congress has increased income tax rates so that now John is in a 50 percent tax bracket. His Roth IRA would be unaffected since such distributions are not subject to federal income taxes. Thus, John keeps all $15,000. If, instead, he had invested in a traditional IRA, he would be subject to a $10,000 tax (i.e. half of the entire distribution). After taxes, he would only retain $10,000, as opposed to the $15,000 from the Roth account.
There are two limitations with Roth IRAs. First, in 2013, you may only contribute $5,500 to your IRA, plus an additional $1,000 if you’re 50 years old or older. Secondly, once your income level reaches $112,000 if single, or $178,000 if filing jointly, the maximum amount you may contribute to a Roth IRA begins decreasing. If your adjusted gross income reaches $127,000 if single, or $188,000 if filing jointly, you cannot contribute to a Roth IRA for that year.
If you are interested in getting more information to see if a Roth IRA is right for you, just give us a call.