Ask Liz Weston

Get smart with your money

Roth IRA

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.

Q&A: Does a teenager need a Roth IRA?

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Dear Liz: Our 16-year-old daughter has been frugal since she started understanding money at about age 6. She works and makes a decent income for a high school student. Her savings are now quite substantial. She wants to open a Roth IRA while she is young and has no income tax liability. My wife and I have pensions and substantial savings but only one IRA. So we have no idea how to help her open a Roth. What should she do? She has enough money to maximize her contributions every year through high school and college and wants to take full advantage of 50 years of tax-free growth.

Answer: Contributing to a Roth IRA is an excellent way for young people to build wealth, and the earlier they can start, the better.

Traditional IRAs typically offer a tax deduction for contributions but withdrawals are taxable. Roth IRAs, by contrast, don’t offer an upfront tax deduction but withdrawals are tax free in retirement. Opting for a Roth over a traditional IRA makes sense when you expect your tax rate to be the same or higher in retirement.

A $6,000 contribution at age 26 can grow to about $105,000 by retirement age, assuming 7% average annual returns. (That’s a reasonable average for a multi-decade investment in a diversified stock portfolio.)

Make the same contribution at age 16, and the money could grow to over $210,000 by age 67. The extra 10 years of compounded gains effectively doubles the total.

To contribute to an IRA or Roth IRA, people must have earned income such as wages, salary or self-employment income.

They’re allowed to contribute 100% of their earnings during the tax year or $6,000, whichever is less. (People 50 and older can make an additional $1,000 catch-up contribution.) If your daughter earned $4,000 this year, for example, that’s the maximum she could contribute to a Roth for 2021.

Your daughter typically can’t open her own account until she’s 18, so you would need to find a brokerage that offers custodial Roth IRAs. She would be the account owner and you would be the custodian until she turns 18. Fidelity, Schwab and Vanguard are among the discount brokerages that offer custodial Roth IRAs without requiring minimum investments or charging maintenance fees.

Q&A: Restrictions on Roth IRAs

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Dear Liz: I read your useful summary of the advantages of Roth IRAs. I recently retired and decided to open a Roth (I know, pretty late) alongside my traditional IRA. I have an investment manager who will hopefully create some gains in that account. One thing that I learned is that I must wait five years before I can begin withdrawing earnings from the Roth tax-free. For this reason, it might be helpful to encourage readers to open a Roth IRA early, with at least a small contribution, to get the clock ticking toward that five-year deadline.

Answer: The five-year rule applies, as you mentioned, only to earnings, since contributions to a Roth IRA can be withdrawn at any time. Once you’re at least age 59½, earnings can be withdrawn without penalty provided the Roth IRA has been open for at least five tax years.

Hopefully you were also informed about the “earned income” rule, which requires you to have earnings — such as wages, salary or self-employment income — in order to contribute to a Roth or traditional IRA. Contributing more than you’re allowed to an IRA or Roth IRA can incur a 6% excise tax per year for each year the excess contributions remain in the account.

If you do have earned income — say you’re working part time in retirement — you can’t contribute more than you earn. If you earn just $5,000 in a year, for example, you can’t contribute the full $7,000 that’s otherwise allowed to people 50 and older. (The contribution limit is $6,000 for younger people.)

If you’ve contributed in error, contact a tax advisor about next steps.

Q&A: Why you might want a Roth IRA

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Dear Liz: I never understood Roth IRAs. They don’t offer a tax break for contributions, so they cause you to pay taxes on your money when you’re working and in a higher tax bracket. With a regular IRA, you get a tax break upfront when you’re in the higher tax bracket and then you pay taxes on withdrawals when you’re retired and in a lower tax bracket. What am I missing?

Answer: Not everyone will be in a lower tax bracket in retirement. Some will be in the same bracket or a higher one when it’s time to withdraw the money. People in their 20s, for example, may be in the lowest tax bracket they’ll ever see. People who expect tax rates in general to rise also may wish to hedge their bets by having at least some money in a Roth.

A Roth also can make more sense if you don’t get a tax break for your IRA contributions. That could be the case if you have access to a workplace plan and your income is above certain limits, or if your income is so low that you owe little or no income tax.

Roth IRAs have a few other advantages. Having a pot of tax-free money in retirement can give you some flexibility in managing your tax bill. If a big bill comes up, for example, a withdrawal from your IRA could push you into a higher tax bracket while a withdrawal from your Roth would not.

Roths also don’t require you to take withdrawals in retirement, unlike regular IRAs. You can hang on to the money until you need it, perhaps to pay for late-in-life costs such as long-term care, or you can pass it on to your heirs.

Roths are more flexible in another way: You can always withdraw the amount you contributed to a Roth without tax consequences. Withdrawals from IRAs before retirement typically incur both taxes and penalties.

Q&A: Roth IRA contributions

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Dear Liz: I am a retired public employee and receive most of my compensation in monthly payments, for which I get a 1099R form at tax time. The rest of my compensation also comes in monthly installments and I receive an annual W-2 for that. My question is: Can I deposit my W-2 amount in a Roth IRA?

Answer: You must have earned income to contribute to an IRA or Roth IRA — which you apparently have, since you’re getting a W-2 form from an employer. Your ability to contribute to a Roth begins to phase out with adjusted gross income of $125,000 if you’re single or $198,000 if you’re married filing jointly.

Assuming you’re 50 or older, you can contribute a maximum of $7,000 or 100% of what you earn, whichever is less.

Q&A: Managing retirement savings

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Dear Liz: I’m considering converting an old 401(k) to a Roth IRA. Will the gains from the 401(k) account be treated as capital gains? And can you only convert 401(k) plans you no longer participate in, or can you convert both current and former 401(k) plans?

Answer: You’ll pay income taxes on the conversion. Retirement plans, including 401(k)s and IRAs, don’t qualify for capital gains tax rates. You may be able to convert your current 401(k) as well. Ask your plan administrator if “in plan Roth conversions” are allowed.