Roth IRA is one of the best tax planning vehicle you can use but also one of the least understood. Traditional IRA’s have been available since 1974 but Roth IRA’s are only about 15 years old. A lot of baby boomers have not been able to learn and/or take advantage the Roth IRA offers for many reasons. In a lot of cases, they are cheating themselves, their dependents and helping the government by paying higher taxes.
Roth IRA’s follow most of the same rules as Traditional IRA’s but have a distinct advantage. Some of the “same” rules are income limitations, contribution limitations, penalties for early withdrawals etc. When a person diligently contributes to a Traditional IRA, the contributions are pre-tax, meaning they are tax deductible. Roth IRA contributions are after-tax, they are not tax deductible. Investments in either type of IRA grow tax deferred.
The big difference occurs when it comes time to take a distribution. In a Traditional IRA, 100% of the distributions are taxed as ordinary income. In a Roth IRA, the distributions are 100% tax free. Ask yourself which you like better!
More Roth IRA Advantages
As stated above, both types of IRA’s share some of the same rules. The IRS has determined that distributions from a Traditional IRA taken before the age of 59 ½ will attract a 10% penalty tax. However Roth IRA contributions have already been taxed so you can withdraw them at any time and the penalty tax does not apply. The tax would apply if you withdraw more than your contributions – but only for the amount of gains you withdrew.
Roth IRA’s have two thresholds to be aware of. The IRA must be in existence for five years AND the Roth owner must reach the age of 59 ½ . Once both thresholds are met, the tax deferred gains change to Tax Free and that is a wonderful thing.
You can make regular contributions and rollover contributions after the age of 70 1/2. This is not allowed with a Traditional IRA.
A little known option is converting a Traditional IRA into a Roth IRA. It is very easy to do but will result in a taxable event. Think of it like this, a Roth conversion is similar to taking the Traditional funds out with your left hand and putting them into a Roth IRA with your right hand. The fact you “handled” the money makes the conversion a taxable event. The amount of dollars you convert will be added to your taxable income in the year the conversion takes place. The 59 ½ penalty tax does not apply to the conversion. However the funds are now Roth and the Roth rules take over.
Eligibility for Roth IRA
Roth IRA eligibility is dependent on two factors:
- The person’s current adjusted gross income – commonly referred to as modified AGI
- The person’s tax filing status – married filing jointly, married filing separately, single, head of house etc.
Roth IRA contributions must come from earned income. If you file your taxes as married filing jointly you can make maximum contributions if your AGI is less than $204,000.
Contribution Limits for 2022
- $6,000 if you are under 50 and $7,000 if you are 50 or older
There is no limit for rollover contributions.
Self Directed Roth IRA’s
Roth IRA’s must have a custodian – same as a Traditional IRA. Choosing the right custodian is very important. Banks, Trust companies and brokerage firms are one type of custodian to consider. They will all open a Roth IRA and let you choose what to invest in – BUT – your investment choices are limited to the products they have to sell.
At Self Directed Retirement Plans LLC, we create true checkbook controlled self directed IRA’s. You may choose to invest in traditional products – stocks, bonds etc. – but you now have the opportunity to invest in alternative investments. A small sample of alternative investments are: Real Estate – directly or indirectly, single family or commercial, off shore, tax liens, private placements, precious metals, hard money loans etc. A good financial advisor will always try to diversify your portfolio but in most cases he is handicapped because he is limited to what he can offer. Imagine having true diversification!! Remember, although there are contribution limits, there are NO limits on how much your Roth IRA can EARN.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He brings over 30 years of diverse experience as a financial advisor. Rick takes great pride in giving honest and very experienced advice. Rick can readily converse with business owners and people looking to take control of their retirement accounts.