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What you MUST know about Roth funds?

What you MUST know about Roth funds?

November 06, 2020
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Welcome to the Weekly SUMmary - 11/06/2020

First, what is a Roth?

"A Roth IRA is an IRA that, except as explained below, is subject to the rules that apply to a traditional IRA.

  • You cannot deduct contributions to a Roth IRA.
  • If you satisfy the requirements, qualified distributions are tax-free.
  • You can make contributions to your Roth IRA after you reach age 70 ½.
  • You can leave amounts in your Roth IRA as long as you live.
  • The account or annuity must be designated as a Roth IRA when it is set up.

The same combined contribution limit applies to all of your Roth and traditional IRAs."1

Now, as we know the IRS isn't always the easiest to interpret, let's break that down:

  • Every dollar that has been contributed to a Roth is POST TAX. (That said, there are Roth contributions that have never been taxed. If you're interested in learning more, we should talk.)
  • Basically, the way it works is, if you have had funds inside the Roth for 5 years, and you're over 59 1/2, you can take a distribution. One extra added benefit is that, since you made the contribution post tax, you can take a distribution of your contribution any time.
  • Contributions after 70 1/2, now 72, are allowed.
  • There are no Required Minimum Distributions on a Roth, as long as the owner is alive. This makes it an attractive option for Estate Planning.
  • The last bullet is self explanatory.

There also may be a Roth option in Retirement Plans (through employer, 401(k), 403(b), 457). The rules are similar, but the contribution limits are quite different, currently the same as IRA vs 401(k)/403(b)/457 limits.

The largest consideration is relating to when you pay taxes on this investment. What most will say is that in the long run, Roth accounts would be much more beneficial. It's more complicated than that. In a Roth, you're paying taxes now and getting potentially tax free growth. On a traditional/non-Roth account, you are not paying taxes, but will on the future value upon distribution. Let's use a real world example.

  1. John Doe makes $100,000 and puts $10,000 in his 401(k). Every dollar gets invested immediately. John doesn't make any additional contributions and receives a 5% rate of return for the next 20 years. His account balance is approximately $26,533. He has to pay taxes on every dollar that comes out. Assuming the tax rate does not change throughout the entire distribution period, assuming 25% tax rate, he will have paid approximately $6,633 in taxes.
  2. Jane Doe makes $100,000 and puts $10,000 of her income in her Roth 401(k). She pays taxes on every dollar that goes into the account, never to pay taxes again (as long as she follows the rules). The $10,000 after 25% tax is $7,500. Assuming 5% growth over 20 years, her account balance would be approximately $19,900.
    • To summarize, John will have paid $6,633 in taxes to Jane's $2,500. But subtracting $6,633 from $26,533, John also winds up with $19,900 after taxes.

The point is, there are many things to consider.

  • Tax rates now vs in the future (see previous blog post on historical rates here),
  • Income level during contribution vs distribution,
  • Whether you can afford taxes now vs delaying until you can afford to pay taxes.

No part of this blog is to be construed as advice, but purely for educational purposes. If you would like to address this subject more, seek a professional.

  1. https://www.irs.gov/retirement-plans/roth-iras
  2. Additional information comes from time, experience and education in financial services.
  3. Calculations done on a financial calculator.

 

You may take nontaxable withdrawals before age 59½ if the Roth IRA is held for at least five years and you meet certain distribution guidelines. Otherwise, an early withdrawal before age 59 ½ may be subject to taxes and a 10 percent federal tax penalty. Please discuss with your tax advisor prior to making financial decisions.  

This hypothetical example is for illustration purposes only and is not intended to be representative of actual results or any specific investment, which will fluctuate in value. The determinations made by this example are not guarantees or projections, and no fees/expenses are included in the calculations which would reduce the figures shown. Please keep in mind that it is possible to lose money by investing and actual results will vary.

This is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.

(11/20)