In the wonderful world of retirement investment accounts, we hear many different terms like Traditional, After-Tax and Roth. So, what does “Roth” mean and how is this different than Traditional?
First, let’s understand what a Traditional retirement account is. A Traditional retirement account is funded with Pre-Tax contributions and grows on a tax-deferred basis. Upon reaching the age of 59 ½, you become eligible to begin taking penalty-free withdrawals taxed entirely as ordinary income. At your age 72, withdrawals from your Traditional retirement accounts become required by the IRS, known as Required Minimum Distributions.
Now let’s compare a Traditional retirement account to an After-Tax retirement account. Similar to a Traditional retirement account, your investment grows on a tax-deferred basis, but your contributions are made with after-tax dollars. At age 59 ½, you can begin taking penalty-free withdrawals where only the growth above your basis is taxed as ordinary income, the rest is distributed tax-free as a return of principal.
Roth... Roth retirement accounts are funded with after-tax dollars (like an After-Tax account) and grow tax-free! There are some limitations. Like Traditional and After-Tax accounts, you must be over the age of 59 ½ to take penalty-free withdrawals and have the account open for at least 5-years. But if your withdrawals are Qualified, they are 100% tax free (even on the growth)! And in case that wasn’t good enough, Roth retirement accounts don’t have the age 72 Required Minimum Distribution rule. If you don’t need the withdrawals, you won’t be forced to take them like you would in a Traditional or After-Tax retirement account.
Now let’s talk about the two Roth retirement accounts you will likely see.
Roth IRA accounts are set up by an individual for their own retirement benefit. An individual can only contribute to a Roth IRA if their Adjusted Gross Income (AGI) is under $196,000-$206,000 depending on your filing status. Check the IRS phase-out table for more information. If you’re eligible to make a Roth IRA contribution, your maximum contribution is $6,000 ($7,000 if your 50 years old or older).
Now if your income is above the phase out limit, don’t cut the Roth IRA out of your planning yet. Through a “Backdoor” contribution, you can contribute after-tax dollars to your non-deductible IRA and convert to your Roth IRA account. Conversion of your after-tax IRA contribution is not taxable and there is no AGI limit on Roth conversions.
CAUTION: all IRA account contributions are considered in determining the taxability of your conversion. If you convert any dollars that were contributed pre-tax, tax-deductible or growth from pre-tax or tax-deductible contributions, you will owe the tax on that portion of your conversion.
Roth 401(k) accounts are set up by your employer for your retirement. There are no AGI limits to contribute like there are with Roth IRAs, but there are contribution limits. The maximum you can contribute to your Roth 401(k) is $19,500 ($26,000 if your 50 years old or older). This contribution limit is cumulative for your Traditional and Roth 401(k); e.g. you can only contribute $19,500 to your Traditional and Roth 401(k) combined.
YOU can only contribute up to the maximum in your Traditional and Roth 401(k), but that does not mean that’s the maximum that CAN be contributed to your 401(k). Your employer can also make contributions to your 401(k) and you can make After-Tax 401(k) contributions that can later be converted to Roth in an in-plan Roth conversion. IRC Section 415(c) limits TOTAL contributions to 401(k) accounts at $57,000 ($63,500 if your 50 years old or older).
Here’s an example:
40-year old employee contributed maximum to their Roth 401(k) $19,500
Their employer matches 6% of the employees $200,000 W2 $12,000
The employee can make an additional After-Tax contribution $25,500
TOTAL 401(k) Contribution $57,000
If you have questions, reach out to one of our Advisors today!