As a CFP® professional I’m always asked what are the smart money moves that someone should make. The tough part about personal finance is that it’s, well, personal. What works for one person might not work for you and vice versa. However, there are a few money moves that I think are worth exploring to decide if they’re right for you: Consider a high-yield savings account, use a mobile app or Excel spreadsheet and budget each month, maximize your employer match in your 401(k), and, for some people, if you’re within the income limitations, consider adding a Roth IRA to your financial strategy.
If you aren’t familiar with Roth IRA’s, maybe it’s time to get yourself acquainted. They offer tax-advantages at the time of retirement that more well-known retirement savings accounts like a 401(k) and IRA don’t, and can be a great addition to your retirement saving strategy.
What is a Roth IRA?
A Roth IRA is a different type of retirement savings plan where you make after-tax contributions into the plan and generally, withdrawals are tax-free. As you might have guessed, since your contributions are made on an after-tax basis, they aren’t deductible from your taxable income. This is what makes a Roth different from the more well-known retirement plans like a 401(k) and a traditional IRA. However, Roth IRA’s offer a lot of flexibility and benefits that other retirement savings accounts don’t, such as the ability to withdrawal your own contributions without tax or penalties. If you are within the income limitations, you can contribute to your 401(k) through work, and set up a separate Roth IRA on the side to maximize your contributions.
Roth IRA vs. IRA: What’s the difference?
It’s easy to confuse a Roth IRA and a traditional IRA, however, there are a few key differences between both of these retirement accounts so you can decide which one (if not both) are best for your retirement needs.
- Contributions are made pre-tax and can be tax deductible
- You can invest in a variety of investment options based on which are made available in your IRA
- Any investment growth is tax-free until retirement
- Withdrawals prior to 59 ½ are subject to a 10% federal income tax penalty and you’ll incur taxes based on your tax bracket
- Withdrawals after 59 ½ are subject to federal and state taxes based on your tax bracket
- Contributions are made after-tax and aren’t tax deductible
- You can invest in a variety of investment options based on which are made available in your Roth IRA
- Any growth remains tax-free until retirement
- Withdrawals prior to 59 ½ fall into two buckets (1) your contributions are after-tax and penalty free, (2) any investment gain is subject to a 10% federal income tax penalty and federal and state taxes based on your tax bracket
- Withdrawals after 59 ½ fall into two buckets (1) your contributions are always tax and penalty free, (2) any investment gain is tax-free as long as you’ve had the account for at least 5 years
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Smart ways to use a Roth IRA
Why would someone want to consider a Roth IRA? Good question. Roth IRA’s offer the potential to maximize your retirement savings. Roth IRAs can also be a vehicle for saving for pre-retirement needs, which makes them a flexible option for many people. The good news is that there are no minimum requirements for how much you need to contribute to a Roth IRA. The maximum you can contribute in 2018 if you’re under 50 is $5,500. You can think about it this way:
- Use a 401(k) or traditional IRA on a pre-tax basis with tax-deductible contributions
- Plus, if you qualify, add a Roth IRA on an after-tax basis for the benefit of tax-free withdrawals in the future. (Tip: when you leave your job you will also not be able to make any additional contributions to your 401(k), but since your Roth IRA is not tied to your workplace, you can continue to contribute to your Roth).
With that said, there are some ways to potentially use a Roth IRA in the future, or as part of your overall financial strategy. Of course, before you withdraw money from your Roth, it’s important to remember that you may be minimizing the growth of this account for retirement in the future.
- As an emergency fund: Use a Roth to save for retirement with regular contributions. You could use your Roth to help build your emergency fund since the contributions you make can be withdrawn tax and penalty free at any point in time in case of an emergency, but you might find a traditional or online savings account is an easier or faster way to get to your money when you need it.
- As a college savings fund: Use a Roth to help boost your education savings for the same reasons as above. You can withdraw your contributions at any point in time tax and penalty free. This is an option to consider in addition to other college savings (such as a 529 plan) since you never know if your child will end up going to college or not in the future. If they don’t end up going to college, you have more flexibility in how to use those funds. You could let your Roth IRA grow, or could withdraw your contributions to help assist your child in their post-education plans. It’s important to be mindful of your retirement goals, and to realize that withdrawing from a ROTH IRA prior to retirement may minimize the account’s growth potential.
- As a goals savings fund: Use a Roth to help fund a big goal you’re saving for in the future like a dream trip to Italy or a new car. Just remember to follow the rules above and only withdraw your contributions to avoid the potential for a penalty tax.
- As part of your home down payment: Use a Roth to help fund the down payment as a first-time homebuyer. This is a special exemption that is unique to both a Roth and a traditional IRA. You can withdraw up to $10,000, which is the lifetime maximum, as part of your down payment if you’re considered a first-time homebuyer (aka – you haven’t bought a new home in the last two years). Of course, the disadvantage of withdrawing funds from your retirement fund prior to retirement is that there is less money in the account to work for you.
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Roth IRA limits
One of the drawbacks people may find about Roth IRA’s are the income limitations that come along with it. While these numbers change each year incrementally, it’s important to figure out whether you would qualify for a Roth prior to setting one up. Also, you might want to think about your future income growth potential and how long you think you’ll remain below the income limitations. If you opened a Roth when your income was within the guidelines and then it grew above the guidelines, your investments will continue to grow, but you can’t contribute any additional amount in the years that you are ineligible.
Here’s what you need to know for 2018:
Married filing jointly under 50:
- If your income is under $189,000, you can contribute up to $5,500 in 2018
- If your income is between $189,000 and $198,999, your contributions are limited based on your income
- If you make more than $199,000, you’re ineligible for a direct Roth IRA
Single under 50:
- If your income is under $120,000, you can contribute up to $5,500 in 2018
- If your income is between $120,000 and $134,999, your contributions are limited based on your income
- If you make more than $135,000, you’re ineligible for a direct Roth IRA
Where to open a Roth IRA
Opening a Roth IRA is a fairly simple process. You can open one online through any of the major investment houses, or through a robo-advisor.
When you’re shopping around, it’s a good idea to pay attention to any advisory or trading fees that might be associated with that particular investment platform.
On a side note, many 401(k) plans now offer a Roth option for all or a part of your 401(k) contributions. Make sure you check with your Human Resources department for all the applicable rules and regulations around investing in the Roth option before you decide to make the leap.
Remember: The “right” retirement strategy is the one that works for you
Roth IRA’s have become popular these days for consumers whose tax bracket is likely to rise in the future, and especially if it is expected to be higher in retirement than it is now. If that’s true for you, it means that you may be better off making contributions to a Roth on an after-tax basis now and withdraw your money tax-free when you retire.
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Shannah Compton Game is a CERTIFIED FINANCIAL PLANNER® professional with an MBA and is the host of the award-winning podcast, Millennial Money, where she shares totally relatable and easy to understand financial advice that will actually make you want to talk about money. Opinions expressed by the author are their own.
Haven Life doesn’t provide tax, legal or investment advice. This discussion is intended as general education only. We encourage you to work with your own personal tax or legal professionals and your financial advisor. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.