Last week, we talked about using IRAs—traditional and Roth—to save for retirement. We discussed some of the major benefits and drawbacks of each. I also mentioned that, in regard to Roth IRAs, we had only scratched the surface of the potential benefits. As promised, here are those additional juicy details.
As previously discussed, the major difference between Roth and traditional IRAs is the timing of the taxation of the contributions. With traditional IRAs you get a tax break on all contributions now and taxes are deferred until the time of withdrawal. With Roth IRAs, you get no immediate tax savings on contributions, however that money–and the interest it earns–can be withdrawn tax free during your retirement years. With traditional IRAs, you cannot contribute after age 70.5 and are required to take minimum distributions or “RMDs”. With Roth IRAs, as long as you have taxable compensation and don’t make more than the contribution ceiling amount, you’re eligible to keep contributing as long as you’d like. Plus, unlike traditional IRAs, you aren’t required to take minimum distributions after a certain age. Ok, enough of the recap. Let’s unravel those exciting benefits that Roth IRAs offer.
First of all, let’s talk about withdrawing money from your Roth IRA. As long as the account has been open for at least 5 years, you can withdraw ANY of the money you contributed to the fund (also known as the “basis”) for ANY reason without penalty. It doesn’t matter that you aren’t a certain age—in the IRS’s eyes, you already paid taxes on that money and it is yours to do with what you please. Be careful, though! Notice how I said you could withdraw the money YOU contributed penalty free. This basis does NOT include the growth on the money you contributed. If you choose to withdraw more than you have contributed to the account and are not age 59.5 or older, you can expect to be faced with the dreaded 10% penalty as well as having to pay taxes on the money withdrawn.
An exception to this 59.5 age limit and mandatory 5 year holding period penalty is if the account holder becomes disabled or passes away. In this event, the restrictions for penalty-free withdrawals are waived and all money (both basis and growth money) can be withdrawn without penalty. However it is worth noting that, depending on circumstances, you may be required to pay taxes on some (or even all) of the money withdrawn.
Because of the ability to withdraw contributions without penalty, many people like the idea of using a Roth IRA to help pay for their childrens’ or grandchildrens’ college. Unlike 529 plans which are fully taxable if not used for qualifying education expenses, Roth IRAs allow account holders to withdraw any/all of their contribution money without penalty. This means that you can withdraw the money from the basis of the Roth IRA tax and penalty free to help to pay for tuition and then leave the leftover money not needed for tuition in your Roth IRA to continue to grow to benefit you in retirement.
Another attractive benefit of Roth IRAs is the first time homebuyer’s provision. In the IRS’s opinion, to be qualified as a first time homebuyer, it doesn’t have to be your FIRST time actually owning a house. As long as you haven’t owned a home for the preceding 2 years, you qualify. So what is the first time homebuyer’s benefit in relation to Roth IRAs? Before, we talked about Roth IRA holders’ ability to withdraw any/all basis for any reason without penalty—the caveat was that you couldn’t touch any of the “growth” money (interest and earnings) until after age 59.5 without that 10% penalty. The first time homebuyer’s provision allows Roth IRA account holders who are “first time homebuyers” and have held their account for 5 years or more to withdraw up to $10,000 of growth money for the qualifying expenses related to the purchase of a home—closing costs, down payment, etc. This $10,000 is a lifetime limit, so choose your timing carefully! The $10,000 limit is also per person, so if each a husband and a wife has a Roth IRA and has not exhausted his/her first time homebuyer’s benefit, they could each withdraw $10,000 penalty free for a total of $20,000 to be used towards their qualifying home purchase expenses.
Another benefit of Roth IRAs is the ability to pass on the fund to the account holder’s heirs tax free. As long as the account has been open for at least 5 years and the account is passed on to a spouse, the spouse receives the same treatment as the original Roth IRA holder—no required minimum distributions, no taxes, etc. However, if the account is passed on to someone other than a spouse, the new holder will be required to take regular yearly minimum distributions but those distributions will still be tax free.
Roth IRAs allow their account holders some flexibility in regards to accessing funds. However, just because you CAN access the money doesn’t always mean you SHOULD. Remember, unless you specifically started that Roth IRA to help to pay for your first house or you child(ren)s’ or grandchild(ren)s’ college tuition, odds are that you started it to help to save for retirement. Removing money from your account lessens the amount in the Roth IRA that is able to grow and compound over time and earn you more money. Less money available to compound means a smaller nest egg for you come retirement. Before removing funds from your Roth IRA, consider the ramifications years down the road.
Roth IRAs can be a wonderful way to prepare for your future and save future tax dollars. However, they aren’t for everyone. As we learned in the previous blog, there are earning limits which restrict some higher income earners from contributing to a Roth IRA. Roth IRAs can also be beneficial for unforeseen financial situations that require some additional cash. Here at Wealth Builders CPAs & Consultants, we have an experienced team that lives and breathes finance. Our experienced and friendly staff would love to help you decide which IRA option is best for you and plan for all of those big events in life—first home purchase, college tuition, etc. Call us today and schedule a free initial consultation!
Hanson, Scott. “Using Roth IRA to Pay for College.” CNBC, 3 Feb. 2013, www.cnbc.com/2014/02/03/roth-iras-can-be-a-better-way-to-save–pay-for-higher-education-costs.html. Accessed 2 Oct. 2017.
Hudnett, Alicia Rose. “4 Reasons to Love the Roth IRA.” CNN Money, 17 Mar. 2017, money.cnn.com/2017/03/17/retirement/roth-ira/index.html. Accessed 2 Oct. 2017.
Malone, Matthew. “What is a Roth IRA.” RothIRA.com, www.rothira.com/what-is-a-roth-ira. Accessed 2 Oct. 2017.