Ask Liz Weston

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Roth IRA

Q&A: How to start an IRA for your new Gen Z college graduate

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Dear Liz: My son is about to graduate from college and, as a present, I want to use $10,000 to start an IRA for him. But which is better? A Roth or a standard IRA?

Answer: Congratulations to both of you! Starting a retirement account is a great idea, but you should be aware of the numerous rules that limit who can contribute and how much.

Let’s start with the annual contribution limit, which for 2022 is $6,000 for people under 50. (People 50 and older can make an additional $1,000 “catch up” contribution.) Also, your son needs to have earned income — such as wages, salary or self-employment income — that is at least equal to the size of the contribution you want to make. In other words, he needs to earn $6,000 for you to contribute $6,000. If he’s about to start a full-time job, that probably won’t be an issue, but if he’s not working, or working only part time before starting graduate school, that might further limit how much you can contribute.

For all of those reasons, a Roth IRA contribution may be best. He won’t get an upfront tax deduction but withdrawals in retirement will be tax free. He can withdraw Roth contributions at any time without taxes or penalties, so the Roth can serve as a de facto emergency fund. Obviously, it’s better to leave the money alone to grow, but having access to the cash could be helpful while he builds a regular emergency fund.

Q&A: Reducing taxes in retirement

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Dear Liz: It appears required minimum distributions will force me to take an additional $3,500 per month from my retirement funds starting in four years at age 72. This added taxable draw will greatly impact my income tax liabilities as I’m now fully retired. Are there any strategies at this time to reduce the hit? As my current income tax rate is 12% federal and 9% state, perhaps I should convert some of these funds to Roth IRAs?

Answer: Partial Roth conversions when your tax bracket is low can be an excellent way to reduce future mandatory withdrawals and save on taxes in the long run.

Let’s say you’re married filing jointly and have $60,000 in taxable income. The 12% federal tax bracket ends at $83,550, so you could convert more than $23,000 of your retirement funds without increasing your marginal federal tax rate. Conversions can affect other aspects of your taxes and finances, so consult a tax pro before proceeding.

Another way to potentially lower your tax bill may be to temporarily suspend your Social Security payments and take more from your retirement funds. Because of the peculiar way that Social Security is taxed, people often face a sharp rise and then fall in marginal tax rates when they have other income, something known as the “tax torpedo.” A tax pro should be able to determine if delaying or suspending Social Security payments could help you reduce the effects.

Monday’s need-to-know money news

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Today’s top story: What to do if your home insurer won’t renew your policy. Also in the news: A new episode of the SmartMoney podcast on job scams and maxing out a Roth IRA, how to hand mixed-income friendships, and student loan payments come back for real Feb. 1st.

What to Do If Your Home Insurer Won’t Renew Your Policy
Has a high-risk property left you without insurance coverage? You still have options.

Smart Money Podcast: Job Scams and Maxing Out a Roth IRA
How to spot job scams and how to avoid them.

How to Handle Mixed-Income Friendships
Empathy and realism are key.

Get Ready: Student Loan Payments Come Back for Real Feb. 1
Your financial situation should determine how you handle the final federal student loan extension.

Q&A: Different Roths, different rules

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Dear Liz: I have a Roth 401(k). Are withdrawals from it the same as from a Roth IRA? And how do I move it to a Roth IRA?

Answer: Roth 401(k)s are a type of workplace retirement plan that, like Roth IRAs, allow tax-free withdrawals. But the rules for Roth 401(k)s are somewhat different from those governing Roth IRAs.

For example, a Roth IRA allows you to withdraw an amount equal to your contributions free of taxes and penalties anytime, regardless of your age. Earnings can be withdrawn from a Roth IRA tax- and penalty-free once you’re 59½ and the account is at least 5 years old. The clock starts on Jan. 1 of the year you make your first contribution.

To withdraw money tax- and penalty-free from a Roth 401(k), you typically must be 59½ or older and the account must be at least 5 years old.

In addition, Roth 401(k)s — like regular 401(k)s and traditional IRAs — are subject to required minimum distribution rules that require you to start taking money out at age 72. Roth IRAs aren’t subject to those rules.

Many people roll their Roth 401(k)s into Roth IRAs to avoid the required minimum distribution rules or to have more investment choices. Such a rollover resets the five-year clock that determines whether a withdrawal incurs taxes and penalties, however. If you wait until you retire to roll over your Roth 401(k) and need access to the money, that waiting period could be problematic.

You can roll over your Roth 401(k) after leaving the employer that offers the plan. But you also could ask if your plan allows “in service” rollovers — in other words, rollovers while you’re still working for the employer. Some Roth 401(k)s allow these, although they may be restricted to people 59½ and older.

Tuesday’s need-to-know money news

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Today’s top story: A Roth IRA could help you avoid taxes like the ultrawealthy. Also in the news: How one DUI can nearly double your car insurance, the Child Tax Credit scam, and flying first class for cheap(er) right now.

A Roth IRA Could Help You Avoid Taxes Like the Ultrawealthy
You, too, could lower your tax burden with the right investment account.

One DUI Can Nearly Double Your Car Insurance — Here’s How to Save
On average, auto insurance rates skyrocket 96% after a DUI, our 2021 rate analysis found.

Scam Alert: Child Tax Credit Is Automatic; No Need to Apply
The IRS won’t call, text or email you so beware of unsolicited communications.

You Can Fly First Class for Cheap(er) Right Now
Luxury travel is a bit more accessible.

Q&A: Here’s how to pick the best retirement account

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Dear Liz: Can you explain the difference between a Roth IRA and a Roth 401(k)? What are the benefits of a Roth 401(k)? My company offers it and I am considering beginning to make deferral contributions there while continuing my 401(k) contributions.

Answer: Contributions to Roth IRAs and Roth 401(k)s are after tax, which means you don’t get an upfront tax deduction as you do with traditional IRA and 401(k) accounts. But the money grows tax deferred and can be tax free in retirement.

You typically open and contribute to a Roth IRA at a brokerage, which gives you access to a wide range of investment options. Just like traditional 401(k) accounts, Roth 401(k)s are offered by an employer, usually with a limited number of investment choices.

Roth 401(k)s allow people to contribute significantly more than they could to Roth or traditional IRAs. Roth 401(k)s also allow contributions by higher earners, who might be shut out of contributing to a Roth IRA.

Roth IRA contributions are limited to $6,000 with a $1,000 catch-up contribution for people ages 50 and older. Your ability to contribute begins to phase out at certain income limits. This year, the phaseouts start at $125,000 of modified adjusted gross income for single filers and $198,000 for married couples filing jointly.

Roth 401(k)s don’t have income limits and allow you to contribute as much as $19,500 ($26,000 for those age 50 and older). That is the combined limit for elective deferrals from your paycheck. If you’re under 50 and contributing $10,000 to the pretax portion of the 401(k), for example, you could contribute a maximum of $9,500 to the Roth option.

Roth IRAs and Roth 401(k)s also have different rules for withdrawals. You can remove your contributions from a Roth IRA at any time without paying taxes or penalties. Withdrawals from a Roth 401(k) before age 59½ also can incur taxes and penalties, although you usually do have the option to take loans.

Also, you’re not required to start taking withdrawals at age 72 from a Roth IRA, as you typically are with other retirement accounts, including Roth 401(k)s. You will have the option of rolling a Roth 401(k) into a Roth IRA, typically after you leave your job, so you can avoid minimum required distributions that way.