Roth IRA – A Retirement and an Emergency Savings Fund

What better way to kill two birds with one stone – save for retirement and save for an emergency. Unlike other retirement accounts a Roth IRA has a key advantage others do not – THE EARNINGS ARE TAX FREE! A second advantage that most people do not recognize is that a Roth IRA can be a de-facto savings account for emergency purposes while earning tax free money for the future. Instead of putting money into a savings account for emergency purposes it may be better to put that money into a Roth IRA (up to the max contribution amount).

What is a Roth IRA and why should you take advantage of it if you can qualify for it? The beauty of a Roth IRA is that it is a one of a kind type of IRA account that lets you invest post-tax income (income you pay taxes on at the time it is earned) and then any earnings on your invested post-tax income are tax free when you receive distributions during your retirement (there are a few exceptions where you can receive distributions on the earnings before 59 ½ without penalty and taxation). Whereas, traditional IRAs let you invest pre-tax income (e.g. you get a tax deduction on the amount you contribute in the year you contribute) so when you receive a distribution from the traditional IRA you pay tax on the full distribution amount. Also, in general (excluding a few exceptions such as first time home purchases and some college expenses) if you need to tap into your traditional IRA before 59 ½ you will not only pay tax on the earnings portion of the distribution, but you will also pay an additional 10% penalty. Also, to qualify for tax-free distributions on earnings you will need to wait 5 years from the first time you contributed to the Roth IRA before withdrawing earnings.

Roth IRAs make the most sense if you expect your tax rate to be higher during retirement than your current rate. That makes Roth IRAs ideal savings vehicles for young, lower-income workers who won’t miss the upfront tax deduction and will benefit from decades of tax-free, compounded growth.

While many people are trying to save for an emergency 6 month living expense fund it might be advantageous to put at least part of those funds in a Roth IRA and earn money in a Roth instead of a savings account. With a Roth you can be conservative or aggressive with your investing. You can invest in cash and earn interest with no risk or you can invest in stocks and let it roll. However, if you ever have an emergency and need cash, the amount of post-tax income you invested, not the earnings, can be withdrawn without incurring a penalty or taxes unlike all other IRAs. Therefore, a Roth IRA can be used as a de-facto emergency savings account. However, if you withdraw the earnings on the invested capital (post-tax income) it will trigger a 10% penalty on the amount of earnings you withdraw along with taxes (there are a few exclusions).

As an example, if a 21 year-old puts $5,000 a year into a Roth for 15 years at the beginning of each year and then stops contributing, the 15 years of Roth contributions with an assumed growth rate of 7% each year until age 66 would yield a total of $1,023,394 of tax-free dollars ($75,000 of contributions and $973,394 of earnings). Now if the same person had put $5,000 into a traditional IRA at the same time they contributed to a Roth IRA and had a tax rate of 20% each year they contributed they would have saved a total of $15,000 in taxes ($5,000 x 20% x15) in those years contributions were made, but when they are retired and start withdrawing from their traditional IRA they will pay taxes on the full $1,023,394. For simplistic purposes, if they had a tax rate of 20% at the time of distribution then they would pay a total of $204,679 in taxes if they withdrew the full $1,023,394. As you can see there is a significant benefit to investing in a Roth IRA vs Traditional IRA if you grow your retirement account (pay taxes of $15,000 on the years income is earned on the post-tax income ($5,000 x 20% x 15 years) or pay $204,679 when you start to receive distributions at 66).

As an example, if the 21 year old (from the previous example) now at age 40 needed some cash to help a family member with an emergency and they did not have enough in their savings account they could withdraw up to $75,000 ($5,000 contribution/year at 15 years) from their Roth IRA without paying any taxes or penalties. If he exceeds that $75,000 he may be subject to taxes and penalties on the amount over $75,000.

There is also a “backdoor” method to contributing to a Roth IRA if you are phased out or if you want to convert a Traditional IRA to a Roth. Those transactions will trigger an immediate tax on those “backdoor” amounts. Visit www.rothira.com to get more information about these conversions.

Lastly, there are some rules for investing in a Roth:

  1. For 2019 you can only invest in a Roth if your Modified Adjusted Gross Income (MAGI) for the year is less than $137,000 if you are single (phase out on the contribution amount is between $122,000-$137,000) and $203,000 if you are married (phase out on the contribution is between $193,000-$203,000). Phase out means that if you earn over the minimum amount (for single filers it is $122,000 MAGI and $193,000 for married filers), but earn less than the max MAGI then your contribution amount will be reduced by percentage of the amount you exceed the floor MAGI ($122,000 and $193,000).
  2. The maximum contribution for 2019 is $6,000. If you earn less than the maximum then you can contribute up to the amount you earned (e.g. if you earned $4,000 in earned income then you can contribute $4,000).
  3. If you are over 50 you can make an additional $1,000 contribution for a max contribution of $7,000
  4. You can make contributions to your Roth anytime between 1/1/19-4/15/20 for the tax year 2019

For a more detail analysis about Roth IRAs go to https://www.rothira.com. Please consult a tax accountant if you need further information.