As a young professional, saving for retirement is but one of the many financial challenges you’re probably facing. You may be also saving for a new or larger home, to start a family, or for college for your child(ren).
With these important but potentially conflicting goals, being tax-smart about your saving and investing is key. Let’s explore why a Roth account is so attractive for young professionals who want to save for retirement in a tax-smart way.
What’s a Roth Account?
A Roth RA is an individual retirement account (or “IRA”) that offers significant tax benefits as long as some conditions are satisfied. First established in 1997, these accounts are named after William Roth, a former Delaware Senator who advocated for their creation.
Roth IRAs are similar to traditional IRAs, with the biggest difference being how they’re taxed. A Roth IRA is funded with “after-tax” dollars – that is, you don’t receive a tax deduction for your contribution. But once you start withdrawing money from your account, you won’t owe any tax. In contrast, a traditional IRA provides a tax deduction for the amount contributed, but you’ll pay income tax when you withdraw money. Both types of IRAs allow your contributions and earnings to grow in the account on a tax-free basis.
The Main Advantages of a Roth Account
Roth Accounts Offer Tax-Free Growth
Perhaps the biggest advantage of Roth accounts is that your earnings will accumulate tax-free. That’s a huge tax benefit, particularly for young investors with decades to watch their savings accumulate due to the “magic of compounding”.
If you save in a taxable account – like a checking, savings or brokerage account – you’ll pay taxes each year on the income your account earns. Inside a Roth account, though, interest, dividends and capital appreciation (or capital gains, if you rebalance your account periodically) are all tax-free.
Roth Accounts Have Flexible Distribution Rules
Roth IRAs have withdrawal requirements that are much more flexible than those for regular IRAs and employer-sponsored retirement plans like 401(k)s.
You can withdraw your Roth IRA contributions (the “basis”) at any time, for any reason, without owing tax. And once you each age 59 ½, withdrawals of the earnings in your account are tax-free as well. Prior to then, earnings withdrawn may be subject to tax.
As a plus, there are some exceptions to the withdrawal rules that can benefit young professionals, in particular.
One exception is the “first-time homebuyer” exception. You can use as much as $10,000 of your Roth account balance to buy, build, or rebuild a home, provided you’re a first-time homebuyer. Importantly, the IRS considers you a first-time homebuyer if it’s been at least two years since you owned a home.
You can also make a penalty-free withdrawal from your Roth IRA to pay qualified higher education expenses, or to cover up to $5,000 of the costs of having or adopting a child.
(Almost) Everyone Can Contribute to a Roth Account
One appealing feature of Roth IRA accounts is that there is no age limitation on who can contribute to an account. All that’s is required is that you have “earned income” – which for children can include income from a part-time job or even paid by you for help in your business (the child would need to file a tax return, even if no tax is owed).
Note, though, that you can’t contribute more than you earned, so if you made $3,000, that’s the most you can contribute.
If you’re married, but your spouse has little or no earned income – don’t worry. You can fund a Roth IRA on behalf of your married partner. A spousal Roth IRA contribution is subject to the same rules and limits as a regular Roth IRA contribution.
And you know the old adage that there’s no “free lunch”? Well, in addition to limiting the amount you can contribute to a Roth IRA, the IRS also won’t allow you to contribute at all if you make too much money. For 2021, the income limit for a single person is $140,000, and for a married couple the limit is $208,000.
Backdoor Roth Account for High Earners
If you’re a successful young professional, it’s quite possible that you (and perhaps your spouse, if you’re married) make too much money to meet the income limit. When your “modified adjusted gross income” (or “MAGI”) exceeds a certain level, the IRS starts gradually phasing out the amount you can contribute to a Roth IRA, eventually eliminating the permitted contribution altogether. Fortunately, there’s an increasingly common – and legal – trick to get around that. It’s known as a “backdoor” Roth IRA.
A backdoor Roth IRA isn’t an official type of retirement account, but rather an informal name for an IRS-approved strategy for high-income taxpayers to fund a Roth.
The easiest way to make a backdoor Roth contribution is to make a non-deductible contribution to a traditional IRA and then roll over the IRA funds to a Roth IRA account.
Note that if you have an existing traditional IRA account that you funded with pre-tax dollars, the backdoor Roth contribution strategy can have some unintended tax consequences. In this case, you should consult with your tax professional or financial advisor before taking any action.
When Does a Roth Account Make Sense?
The benefits of a Roth account are most powerful for who are relatively young and who expect to be in a higher tax bracket in the future. Why is that?
Well, remember that your Roth account is funded with after-tax dollars – you don’t get a tax deduction for your contribution, as you do with a traditional IRA or 401(k). But, if you’re in a relatively low tax bracket now, that tax deduction isn’t worth so much. But, in the future, when you expect to be in a higher tax bracket, your Roth withdrawals will be tax-free. So, with a Roth account you’re effectively saying, “Tax me at a low rate now, rather than at a high rate in the future”. Smart, right?
Another reason why Roth accounts are the better choice for young investors is time. Younger people have more time for a Roth account to grow tax-free before they begin taking distributions for retirement, and thus to benefit from the fact that both earnings and those eventual withdrawals will be untaxed.
How to Open a Roth Account
Today, a Roth IRA account can be opened with just about any financial institution, including a wide array of banks and credit unions, mutual fund companies, and brokerage firms.
But not all financial institutions are created equal. Some offer a robust list of investment options, while others limit their selection to (invariably) expensive proprietary or preferred choices. Since asset allocation and investment options significantly impact your returns, you should choose your account custodian carefully.
You can open a Roth IRA at any time. However, your contributions for a particular tax year must be made by your tax-filing deadline, which is generally April 15th of the following year (and tax-filing extensions don’t affect the contribution deadline).
Roth Accounts at Work
As part of a tax law passed in 2001, Congress created the Roth 401(k).
The main differences between regular and Roth 401(k) accounts are the same as those between regular and Roth IRAs. A regular 401(k) account is funded with pre-tax deferrals from your paycheck, growth in your account is tax-deferred, and withdrawals are taxed as ordinary income. A Roth 401(k) account is funded with after-tax salary deferrals, growth in your account is tax-free, and withdrawals are also tax-free.
The appeal of a 401(k) is that the contribution limit is much higher than that for a Roth IRA, and there is no contribution phase-out for high income earners. For 2021, the contribution limit to a 401(k) – regular or Roth – is $19,500 if you’re under the age of 50, and higher if you’re age 50 or older. This limit generally increases from year to year.
Getting Help From an Advisor
Opening and contributing to a Roth account is fairly straight-forward. But making tax-smart decisions like possibly taking advantage of the backdoor Roth option, and selecting the right investments for your Roth (and for the rest of your portfolio) require some expertise. If you’re not totally comfortable you may want to seek the guidance of an investment professional. The CFP Board, the Financial Planning Association, and the National Association of Personal Financial Advisors can all direct you to an experienced, independent, fee-only fiduciary advisor who can help you make the right decisions.
Do you have questions about saving for retirement, or about building a robust plan for your financial future? Contact us today to see how our team at Springwater Wealth can help you.