What is a Roth IRA?
A Roth IRA is a type of retirement vehicle allowed by the IRS that defers taxes on investment earnings into the future. An IRA stands for “individual retirement arrangement” and with a Roth IRA, the goal is to get an improved tax advantage for your retirement investments.
The policies of a Roth IRA are developed by the IRS, as ultimately a Roth IRA is all about taxes on investments. A Roth IRA is an investment vehicle for retirement, and once you decide the destination you are head to in retirement, you can then determine which vehicle you need to get there.
A Roth IRA is not an investment, but an investment vehicle.
When deciding if you want to use a Roth IRA, first ask yourself if you want capital gains tax to impact me today or in the future. When you’re investing for retirement, its important to protect yourself from a tax point of view.
In a traditional IRA, you may get tax deductions you may like now, but their will be tax implications in the future. A Roth IRA has no tax deductions today, but when the investment grows, you may distribute your earnings without tax implications.
In 2022, what are the contribution Limits? What is an income limit?
For 2022, the contribution limit into a Roth IRA is $6,000 per year, which is the same across all IRAs. After age 50, you may add a catch-up contribution of an extra $1,000 per year if you just started a Roth IRA.
For 2023, the contribution limits into a Roth IRA jumps to $6,500, with another $1,000 for catching up if you’re age 50 or older.
The income limit will differ if you’re married filing jointly or single and if you’re contributing into another work-related retirement plan. Generally, if you’re filing jointly, the income limit is $204,000 per year. If you’re filing individually, the income limit is one hundred and twenty-nine thousand $129,000 per year.
The maximum income limit is reduced if you’re contributing to a different plan already. The reduced income limit is then $109k to $129k when filing jointly, and $68k if single or the head of a household.
If your income is too high, are you not able to contribute to a Roth IRA?
If your income is too high, you are not able to contribute to a Roth IRA. But again, remember that the policies around retirement accounts are determined by the IRS. Hence, the definition of what is “high income” may change based on the decisions in congress.
For the most part, you want to choose different investment vehicles if you have a higher income. Investment vehicles are made to give retirement accounts tax benefits, but those tax benefits not only help the individual investor but also the IRS.
If you’re a higher earner today, the IRS wants to tax your earnings today. The IRS doesn’t want to give higher earners a tax advantage plan like a Roth IRA because the IRS needs the tax revenue now.
For low-income earners, the IRS doesn’t want to tax your seed money. It’s too small to tax. The IRS wants to tax your investment account after it grows.
The IRS doesn’t want to tax your seeds, they want to tax the oranges they sprout.
For low-income earners, the IRS wants to defer taxing your initial investments. This allows you to grow your investments faster. The IRS will then tax your account normally at retirement when your investment account is larger.
There are 3 options when building wealth through investment vehicles:
- Tax deductions today, but taxes will be collected later – High Income Earners
- Defer taxes until distributions are made at retirement – Low Income Earners
- Tax free options – High wealth income bracket, special tax accounts
For high-income earners, a Roth IRA is not a choice the IRS wants to give you. You’re a high earner in 2022 if you make $204k jointly or $129k single.
What would be the suggested retirement account for someone with a high income?
When you are a high income earner, there are additional investment vehicles you can use to gain a tax advantage. One method is to start a business; however, this advanced strategy will come with its own tax complications. You have a $54k limit as tax deductible, but their will be tax implications in the future.
For higher earners, they can use a life insurance tax vehicle after maxing out their Roth 401k and IRA. The IRS has the most favorable laws for life insurance. If you pass away, your family gets money tax free from life insurance. When you’re paying a life insurance premium, you can save additional money in your life insurance policy. As an example, if you save $2,000 in your life insurance policy, you can take it out in retirement tax free. Life insurance isn’t typically taxable.
Wealthy people and also organizations take out this money tax free. Life insurance companies give you the opportunity to invest that money in your account. Basically, life insurance is just another investment vehicle.
Insurance is a risk management industry, and they take on that risk management ability to your investment.
But ultimately, all these tax advantages don’t matter if your investments do not grow. If you only make 1% a year on your investments then you still lose to inflation, and the IRA vehicle type just won’t matter.
What is the 5-year rule for ROTH IRA?
The 5-year rule for Roth IRAs is about when you can make withdrawals from your IRA. When you start contributing to your Roth IRA, you need to wait 5 years to make a withdrawal or incur penalties from the IRS. For example, if you decide to start contributing to a Roth IRA at 56 years old with the idea to get the tax benefits when you turn 59 and a half years old, you’ll find out that you’ll get penalized anyways. This is because of the 5-year rule. If you start contributing at 56, you must wait five tax years to start making withdrawals, which roughly means you will wait until you’re 61 to start making distributions without penalties.
Hence, with all tax vehicles, its important to build them into your retirement plan with the supervision of a retirement planner. They can help choose the right vehicle that fits within the full picture of your retirement plan.