Rap Ode To Roth IRA
Here's the thing about Roth IRAs. Pay taxes now, no delays. You won't owe any more while your investments grow. Once you're ready to retire, it's ALL your money to sow! Add contributions up to the annual max, Then pick the investment(s), and see how it stacks! Don't touch the money before age 59 1/2, 'Cuz taking earnings early costs a penalty and tax. Don't wait! Start a Roth soon as you can, Earn that compound interest -- That is the plan!
The topic of retirement savings is especially pertinent right now for two reasons: either people are considering tapping into retirement savings as cash runs short or on the opposite end, they are looking to invest more money while market prices are low. One type of retirement savings account, the Roth IRA, caters to both. Let’s dive deeper into both scenarios.
Roth IRA – Taking Money Out
Contributions to a Roth IRA can be withdrawn with no penalty and no tax at any time, as they were taxed once already. This is one retirement savings vehicle that offers more withdrawal flexibility than others. However, earnings, or how much your money grows, are subject to both tax and a penalty if taken before age 59 1/2. There are some exceptions to this rule, but a Roth IRA is largely meant to be used for retirement savings.
In response to financial hardships caused by COVID-19, the CARES Act changed a few rules this year. For those in financial need, the early withdrawal penalty on Roth IRA earnings is waived for 2020, and distributions up to $100,000 are allowed before age 59 1/2. These distributions of earnings are considered income and will be taxed as such, but there is the option to spread the tax burden over 3 years or pay back the “loan” within 3 years to avoid paying taxes. Before you withdraw from your Roth IRA, carefully consider what this means for your retirement. In addition, taking money out of any investments could mean selling at a loss. Consult your financial advisor and tax advisor if you are contemplating a withdrawal of retirement savings.
Roth IRA – Adding Money In
For those in a position to invest right now, adding money to a Roth IRA (up to the max) not only takes advantage of stock market lows, but also yields more tax savings down the road if you expect to be in a higher tax bracket in the future. The Roth IRA works especially well when investments have a long time horizon for growth because you get to keep every penny gained without sharing a cut of the profits with taxes.
An attractive option this year may be a Roth conversion, which converts an existing IRA to a Roth IRA by paying taxes on the amount converted. If your income is lower this year than most years, you may fall in a lower tax bracket and therefore, pay less tax on that Roth conversion than you normally would. Furthermore, as a result of the market downturn, your investments may be worth less than previously, so less taxes would be owed. It’s a good idea to check with a financial advisor and tax advisor before making these financial decisions.
Making The Right Choice
No matter the impact that COVID-19 has on our financial lives, savings are still important. In fact, times like these make us realize that having savings gives us one more safety net when falling on hard times. So regardless of whether you are saving for retirement or saving for a rainy day, the point is to remember to SAVE!
Homework: Pay tax now or pay tax later? One reason to choose a Roth IRA (pay tax now) vs. traditional IRA (pay tax later) is if you believe your tax rate will be higher when you withdraw the money. Use the following math problem to understand the difference.
Say you earn $5,000 this year that you pay 20% tax, or $1,000, and you decide to contribute the remaining $4,000 to a Roth IRA. You add no more money to that investment, and it averages 6% annual growth over the next 36 years — How much will your total investment be? (Hint: Use the Rule of 72 to get $32,000 for the Roth IRA.) Assume instead that you defer paying tax until withdrawal by investing the full $5,000 in a traditional IRA– How much will your total investment be after 36 years of 6% annual growth? ($40,000.) After 36 years, if your tax rate is 20%, your total investment will net the same amount in either the Roth IRA ($32,000) or traditional IRA ($32,000) after taxes. If your tax rate decreases to 15% after 36 years, the traditional IRA ($34,000) nets more than the Roth IRA ($32,000). If your tax rate increases to 25% after 36 years, the traditional IRA loses ($30,000), and the Roth IRA wins ($32,000).