Guide to the ROTH IRA: Summary of features and specs.

Ready to dive into the world of ROTH IRAs? Great choice! These retirement accounts can be beneficial when pursuing a solid financial future, especially if you are not a big fan of taxes. Let’s break it down in plain, understandable terms, shall we?

What is the difference between an IRA and a ROTH?

First, let’s tackle the difference between a ROTH IRA and a traditional IRA. The main distinction is how they’re taxed. You get a tax break on the front end with a traditional IRA. Your contributions may be tax deductible. That means the money you put in reduces your taxable income. But if you only made tax advantage contributions, when it’s time to withdraw your hard-earned cash in retirement, every dollar taken out is added to your income for tax purposes. Sad, I know.

On the other hand, with a ROTH IRA, the taxes are flipped on its head. You don’t get an immediate tax break for your contributions, yet qualified ROTH IRA distributions are tax-free. Yep, you read that right. Plus, you always have access to your contributions (the money you put in), which are treated as a return of principal, AKA tax-free again.

When are distributions from a ROTH IRA tax-free?

Now, let’s talk about what makes a distribution qualified. You need to meet a couple of simple rules to get the tax-free benefits. First, the account must be open for at least five years. That’s the 5-year rule. Second, you must be 59 ½ years old to avoid early withdrawal penalties. And that’s all.

What happens if I take money out of a ROTH early?

Let’s entertain the hypothetical situation where you break the rules and make a non-qualified distribution from your ROTH IRA. Well, my friend, you’ll have to pay taxes and potentially face penalties on the distribution’s earnings portion. Remember, what you put in will still be tax-free, but any returns would be taxed similarly to a traditional IRA. It’s not the end of the world, but it’s not ideal either.

Who qualifies to make ROTH contribution?

But who qualifies to contribute to a ROTH IRA? Great question! The IRS has some income limits in place. Suppose you have earned income (including wages, salaries, or self-employment income). In that case, you can contribute to a ROTH IRA if you don’t exceed those income thresholds.

What can I do if I don’t qualify to make a ROTH contribution or would like to put more in my ROTH?

But what if you no longer qualify to contribute? You may still be able to slide some money into a ROTH. It is a move called the ROTH conversion. You can convert money from a traditional IRA or a 401(k) into a ROTH IRA, regardless of your income. Pretty nifty. Just be aware that you must pay taxes on the amount you convert, so it’s not a free ride, but it can be a prudent move in the right circumstances.

Speaking of ROTH conversions, let’s touch on backdoor ROTHs and their limitations. They sound fancy, but they’re just another way to get money into a ROTH IRA. Earn too much to contribute directly. You can make a non-deductible (no tax benefit) contribution to a traditional IRA and convert it into a ROTH IRA. Since you received no tax benefit on the contribution, there may be little to no taxes generated on the conversion. Voila! It’s the backdoor to tax-free retirement savings. This strategy does have its limitations, especially if you have multiple IRAs, so be sure to speak with a financial advisor to see if this approach would make sense for you.

What is the ROTH IRA 5-year rule?

Ah, the 5-year rule. When does it apply? The 5-year rule kicks in regarding withdrawals from your ROTH IRA. Specifically, it helps determine whether your distributions are tax-free or not. However, the rule only becomes relevant when you turn 59 ½. Remember, to get the tax-free benefits, your ROTH IRA must be open for at least five years, and you must be at least 59 ½. So, patience is vital. The 5-year rule does not apply to pulling out your contributions.

Are ROTH 401ks and ROTH IRAs the same?

Now, let’s clear up the difference between a ROTH IRA and a ROTH 401(k). Think of a ROTH 401(k) as the big brother of the ROTH IRA. While a ROTH IRA has income limits, a ROTH 401(k) doesn’t discriminate based on how much money you make. If your employer offers one, you can contribute and enjoy the same tax-free benefits as a ROTH IRA.

However, a ROTH IRA has greater flexibility compared to a ROTH 401k. ROTH IRAs tend to have investment options, are portable regardless of employment status, and you always have access to your contributions.

Remember, some additional benefits of a ROTH IRA, such as no required minimum distributions (RMD). Unlike traditional IRAs and 401(k)s that force you to withdraw money when you hit a certain age, the ROTH IRA allows you to leave your money sitting pretty for as long as you like, allowing it to grow.

One final note: the five-year timer is not shared between the ROTH 401k and the ROTH IRA. So, suppose you plan on moving ROTH 401k into the ROTH IRA. In that case, you must open the ROTH IRA for at least 5 years before taking advantage of the tax-free distribution benefit.

When should I consider investing in a ROTH?

Lastly, let’s talk about the benefit of saving into a ROTH IRA before a traditional IRA. While it may seem counterintuitive to pass up those potential tax breaks, sometimes playing the long game pays off. By contributing to a ROTH IRA early on, you’re setting yourself up for tax-free growth and potentially avoiding higher tax rates.

Additionally, since the money will have more time to grow, you may need fewer contributions to generate significant funds in an ROTH before enjoying the potential tax benefits of contributing to a traditional IRA. Funding a ROTH and Traditional IRA during your working life is like having chips and guacamole. They are both excellent, but together, they are the bomb.

So, there you have it, your guide to ROTH IRAs. We’ve covered the basics, the ins, and the outs of this powerful retirement tool. Remember, my friend, creating a retirement plan can be easy with the right tools and financial advisors.

Our mission is to identify goals and nurture behaviors so that together, we can confidently discover and pursue dreams. If you’re looking for financial guidance, schedule a call today.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Written by Mark R Tracy, MBA, CFP® in collaboration with and Grammarly.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Enduring Wealth Advisors, LLC, a registered investment advisor. Enduring Wealth Advisors, LLC and Enduring Wealth Advisors, INC are separate entities from LPL Financial.

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