To answer the title question, William Victor “Bill” Roth, Jr. (July 22, 1921 – December 13, 2003) was an American lawyer and Delaware Senator. He was a member of the Republican Party and World War II veteran. Roth was an outspoken proponent of the American dream and noted to Dr. Gobind Daryanani that, “If you work hard and save hard, you can have a good retirement income that allows you to leave something to your children.” He worked with the Senate Finance Committee to develop his namesake IRA which was established by the Taxpayer Relief Act of 1997. The basic premise of a Roth IRA is that you can invest after-tax dollars and those dollars can grow tax-free which was in line with Roth’s preference of wanting to attract both young investors as well as seasoned ones. The Finance Committee was eager to see younger working Americans starting their retirement investing earlier with even small amounts of money, thus developing a culture of saving.
What is the Roth IRA?
Now that you know a little more about the man behind it, let’s talk about Roth IRA specifics. Let’s walk through a hypothetical example of how a Roth IRA works and then I’ll breakdown the components:
In early 2015, you contribute $5,500 into a Roth account. In late 2020 you are age 59 ½ and decide to buy a boat. That $5,500 has grown to $10,000. You withdraw the $10,000, buy your boat, and owe no taxes on the $4,500 investment gain ($10,000 - $5,500). You then toast Uncle Sam from the helm of your new boat and happily sail away.
Now let’s get a little more granular on each piece of the example:
- Contribution amount: In 2015, the Roth IRA contribution limits are $5,500 if you are age 49 and below or $6,500 if you are age 50 or older thanks to a catch-up provision. Remember from my previous article, you must have earned income of at least the amount you are contributing, except for the spousal IRA which even then the contributing spouse must still have sufficient earned income.
- Time period (e.g. 2015-2020): To take full advantage of the benefits of a Roth, you need to have the account open for 5 years before your first withdrawal of earnings. This rule is often overlooked; however, if your account has not been open for 5 years and you take a withdrawal of earnings (e.g. money above and beyond the principal), you will be taxed and assessed a 10% penalty on those earnings withdrawn (10% penalty applies if you are under age 59.5).
- Age 59 ½: This age is a common denominator among IRA accounts because once you reach that age, you can take penalty free qualified distributions of principal and earnings from your account, provided you’ve met the 5-year holding rule as noted above.
- Withdrawals: An important note about withdrawals is that you can withdraw your contribution amount in your Roth IRA at any point in time with no penalties or taxes – that means you can always have access to the $5,500 in the example above because you have already paid taxes on that money. It is when you withdraw the gains on that initial contribution ($4,500 in gains in the example above) that you must be mindful of the rules (e.g. 5-year rule, age 59 ½ rule, etc.) to avoid a tax/penalty. There are special circumstances that will allow the waiver of the penalty before age 59 ½, such as a first-time home purchase, but those are few and far between.
- No taxes: If you follow all of the rules set in place for a Roth IRA, and do not take a non-qualified withdrawal before age 59 ½, you will be entitled to tax free gains and withdrawals on your investment assets. This can be a huge benefit, especially if you are older and have other income sources (e.g. a pension, social security, required distributions from an existing IRA, etc.) which force you into a higher income tax bracket.
The tax free distribution of gains makes the Roth IRA an attractive investment option for most people. There are specifics you need to be aware of such as income limits which differ if single or married filing joint and “backdoor” Roth options even if you exceed those limits. We have the tools and knowledge to help you sort through any questions you may have around a Roth IRA.
Between the nuances of a Roth versus traditional IRA and the associated tax impacts of each, determining which type of IRA to contribute to can be difficult. If you want to walk through this together, feel free to reach out to me at [email protected].
Content in this article is not intended to be financial advice. Instead, we think of it as educational, and financial education is important to us. Retirement and financial planning services at the Cincinnati firm Hengehold Capital Management.