IRA
Roth IRA: The "Liquid" Retirement Savings Account
By Amy Rose Herrick
Amy Rose Herrick, ChFC, IAR Economic Consultant, Amy Rose Herrick, ChFC, Economic Consultant
One key component of the Roth IRA that is rarely mentioned is the sunset tax provision that mandates these tax free savings vehicle options will cease to be an option unless the provision is renewed in 2010. What this means to you and your investment planning is that these accounts need to be funded now as a priority while your funding window of opportunity is still open, in the event this window of opportunity to accrue retirement savings income tax free closes again in just few years.
Roth IRA’s are a wonderful vehicle for retirement. In essence, you are paying tax on the “seed” of your initial contribution, never planning to pay tax on the “harvest” of earnings at retirement, perhaps 10, 20, 30 or 40 years from now, neither will your heirs.
An IRA, 401(k), or other pre-tax savings vehicles on the other hand is like paying tax on the “seed and the harvest”. Yes, you do deduct the initial contribution if you are qualified, and there are some upfront tax savings, but you or your heirs will pay tax on everything when it is withdrawn in the future at whatever tax rate is in place at that time on the recipients income.
How is a Roth IRA Liquid? Well, if you do withdraw only your initial contribution, but you leave all the earnings alone to continue to grow, there is no early withdrawal penalty tax, or income tax due! Surprised? This little talked about nuance can make a big difference on whether it is funded on any given year, or if the funds are invested in taxable investments because of the fear you may not be able to leave it until age 59 ½ or later.
Most articles focus on the provision you have to let the account remain invested for at least five years to withdraw the account balance to be tax favored. The account balance would include earnings for it to be a tax free withdraw of the full amount. This is a subtle, but important point to understand about withdrawing your basis, versus the account value.
Consider a couple of any age below 59 ½ struggling to build an emergency fund and wanting to save for retirement too. If they fund an IRA, if they must access the funds early they will pay dearly in a 10% early withdrawal penalty plus Federal and possibly State income taxes, losing 40% or more in tax liabilities for every dollar withdrawn. This is not a very attractive risk to lose 40% of your money with the cutting of a redemption check.
If they use a 401(k) to receive the company matching dollars, it may be virtually impossible to access the funds if needed unless they quit and change jobs. The same harsh tax penalties as the IRA would be imposed with early withdrawal. This is not a very attractive scenario.
If they used a ROTH IRA instead, and needed the funds, the tax penalty on the contribution would be zero. There would only be a tax liability if they withdraw earnings. So, as long as earnings are left to grow, a substantial portion of the account could be accessed with little economic pain.
For another perspective, let’s pretend a 37 year old married investor after visiting with a qualified debt professional as a last resort needed $10,000 from their IRA retirement account in Kansas. They would need to pull out and remit enough before tax filing time (to avoid even more underpayment penalties) to pay the 10% Federal early withdrawal penalty, 6.45% State income tax, and 25% Federal income tax on the withdrawal, a total of 41.45% will be lost to taxation. To net the $10,000 needed, a $17,080 gross distribution would be required from the IRA. $17,080 – 7,080 tax due = net $10,000 needed.
In contrast, if they had a ROTH IRA they had contributed to, as long as all they withdrew was contributions, and no earnings, they would pull only $10,000 to accomplish the same net amount as the IRA with no income tax liability, quite a different result than if they had used the IRA as the withdrawal vehicle.
Keep in mind that extra $7,080 withdrawn from the IRA to pay taxes will never earn another dime for you either. If it was left invested for the next 30 years to age 67, at an average of only 8%, it would have grown to over $71,000 in your account.
Before you think you can’t afford to fund any after tax money into a ROTH IRA, visit with a qualified professional to learn what your options may be. There are options to start a ROTH IRA with as little as $250 if you know where to look. No two households are the same, so it will pay you handsomely to know what your specific options will be.
Click here to submit request>
Go Back to Topic Page>
If you are an advisor and would like to see your articles published, click here
Article reprinted by permission. Unauthorized reproduction of content prohibited.
|
