Roth IRA Basics

April 25, 2024


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Roth IRA Basics

Today, we are going to be talking about the Roth IRA and how it can be an important part of your retirement plan, or an important account to open if you are just starting investing.

So, what is a Roth IRA? A Roth IRA is an individual retirement account that you fund using money that has already been taxed, that money then grows tax-free, and can be withdrawn tax-free once you reach the age of 59.5, with a few exceptions. So, you don’t get a tax break up front, but your contributions and investment earnings grow tax-free.

To be eligible to fully contribute to a Roth IRA, you must have earned income below $146,000 (single filers) or below $230,000 (married filing jointly). In 2024, the contribution limit is $7,000 or $8,000 if you are over 50.

What if you need to take money out before 59.5? You can withdraw your original contributions tax and penalty free whenever you want. There are also a handful of a circumstances where you would not pay taxes or penalty on an early withdrawal. For example, if you are a first-time home buyer you can withdraw up to $10,000 of Roth IRA earnings without taxes or penalties. If you withdraw earnings that don’t meet any of the special circumstances you will owe federal income tax and a 10% penalty on any earnings that are withdrawn.

Having a Roth IRA as part of your retirement plan can be very important. Say you want to withdraw an extra $20,000 from your retirement accounts to fund a vacation, but you don’t want it to affect your tax bracket or Medicare premiums. Withdrawals from a Roth IRA do not count as earned income, so this withdrawal will not affect your tax bracket or Medicare premiums.

If you are just starting investing, a Roth IRA may make sense for you. Since you fund a Roth IRA with after-tax money, it could make sense to fund the account when you are younger and in a lower tax bracket than you will be when you are closer to retirement.

Let’s look at a scenario where it may make sense to contribute to Roth IRA instead of Traditional IRA or 401k, where you would get a tax deduction now and then pay income tax when you withdraw the money in retirement. In this example, let’s say the client is 25 years old and their average tax rate is 15%. When this client decides to retire at age 65, since their income is higher than when they were 25, let’s say their average tax rate is 20%.

If they want to contribute $1,000 to their Roth IRA at age 25, after taxes they would be able to put in $850. If they contributed to a pre-tax retirement account, they would put the entire $1,000 in now and not have to pay the $150 in taxes.  Let’s just say that each investment has grown 10 times as big at retirement time. The Roth account with $850 would now be worth $8,500 and the pre-tax account with $1,000 would be worth $10,000. If they were to withdraw the full amount from both accounts, they would be able to take the $8,500 from the Roth IRA tax free but would owe taxes on the $10,000 in the pre-tax account. Since they are in a higher tax bracket at this point, after taxes they would only be left with $8,000, $500 less than the Roth IRA. In this case, contributing to the Roth IRA resulted in a total of $350 in tax savings. This is a great example of why it could make more sense to contribute to a Roth IRA when you are in a lower tax bracket.

This has been a basic introduction to the Roth IRA, if you have any further questions, you can reach out to any of us here at New England Capital and we would be happy to have a conversation with you.


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