The Roth IRA as a Tax Planning Tool

| January 11, 2023

Taxes may be one of your biggest concerns when it comes to retirement. Whether you’re well into your retirement or just starting to think about it, taxes can be one of the main factors in maximizing your savings to stretch all the way through retirement. The Roth IRA can be a great investment vehicle for tax-free income after reaching retirement age.

The main benefit of the Roth IRA is that it is a tax-advantaged investment vehicle. However, there are penalties for misusing it. To avoid penalty fees, aim to take Roth IRA distributions after age 59 ½ when withdrawals are tax-free and penalty-free. Watch out for the five-year holding period in which you’re required to hold your investments in the account for five years before withdrawing, regardless of how old you are. Also, because the Roth IRA doesn’t defer taxes, you want to make sure that you contribute to a Roth IRA in years when you are in a comparatively lower tax bracket. A Roth IRA can benefit from compounding interest too, so in some cases the earlier you start the better.

You might also be wondering how Roth IRAs differ from traditional IRAs. Well, your contributions to the traditional IRA are made pre-tax, which means that your contributions to the IRA are not counted as taxable income for your current year but are taxed at your income rate in the future year you decide to take withdrawals. Contrarily, state and federal taxes are paid during the year of contribution for Roth IRAs. It’s also important to know that both traditional and Roth IRAs have yearly contribution limits of $6,500, and the Roth IRA has an annual income limit for regular contributions that phase from $138,000 to $153,000. If your income is in, or above this range, you may have limited or no access to the Roth IRA through regular contributions.

In terms of strategy, the optimal Roth IRA strategy is to contribute to an account as soon as possible and to do so while you are in a lower tax bracket. For many, this financial profile characterizes them in the early stages of their careers. If you start or have started young, it will give you a longer runway for the tax-free compound growth of your account, given that contributions were subject to your lower tax rate.

However, the Roth IRA isn’t only for young income earners. You can perform a backdoor Roth conversion which transfers funds from a retirement account into a Roth IRA. Talk to your financial advisor to see if you can transfer your holdings from a traditional IRA to a Roth IRA. However, watch out for the five-year holding period that applies even after you turn 59 ½ years old. Any withdrawals before that five-year holding period will be subject to the early withdrawal penalty fee.


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