Retirement Planning: What You Need to Know About Roth IRAs & 401ks

roth-ira-401kPlanning for your retirement can be tricky if you aren’t well versed on the ins and outs of this very important life goal. When it comes to your savings plan, there are many options available to you. Two of the newer options include the Roth IRA and the Roth 401k. Both offer tremendous benefits but can be very complex. Below are five things you need to know before opening these types of accounts.

Pay now, not later.

While traditional Roth IRAs and 401ks provide generous tax breaks, the difference lies in the timing. With traditional IRA contributions, you avoid taxes when you put money into your account and you must leave the money in until at least age 59 ½ to avoid a withdrawal penalty. With Roth IRAs, there are no tax breaks for contributions, but you withdraw the principal anytime, tax free. This results in a big benefit for those in a higher tax bracket during retirement years.

Understand the limits.

To be able to contribute to the Roth, you must have earned income in the year you contribute, and unlike traditional IRAs, you can keep contributing past age 70 ½. The maximum amount you can contribute to a Roth IRA annually is $5,500, with an extra $1,000 if you’re 50 or older. Keep in mind that higher income taxpayers (above $114,000 adjusted gross income for single filers and $181,000 for joint filers in 2014) are limited or not eligible to contribute to Roth IRAs. Consult a tax advisor to find out more.

Use your employer.

Recently, many employers have added a Roth option to their 401k plans. If you choose this route and make contributions to a Roth account through your employer, you won’t see any immediate tax savings, but your money will grow tax-free. A Roth 401k is a good option if your earnings are too high to contribute to a Roth IRA.

Consider a Roth conversion.

If you convert a traditional IRA account to a Roth, there is more potential for tax-free earnings. In the year you convert, you must pay tax on the full amount shifted into the Roth. It makes sense to convert if you expect your tax rate to be the same or higher in the future. It is also important to note that you will want to pay the tax owed on a conversion with money outside of the IRA. Drawing money from the IRA to pay the tax could result in an additional tax bill and a penalty if you are under age 59 ½. Be careful if you consider a conversion because it could trigger another tax event like boosting you into another tax bracket.

You must pass the test.

In order to receive tax-free and penalty free earnings, you must pass a couple of tests. First, you must be 59 1/2 or older.  If not, you will get hit with a 10% early withdrawal penalty and taxes if you take out earnings before age 59 ½. In addition, you must have had at least one Roth open for at least five years. There are some exceptions, like education expenses and first time home purchases. Again, consult a tax advisor for full details.

When it comes to retirement planning, it’s important to know your options. But having the right accounts in place is only the first step to building a solid foundation for yourself that will prepare you for financial success both now and in the future. It is also important to ensure that your credit is in good shape. Your credit is the one asset that will determine the majority of your financial decisions. If you are currently experiencing issues in this department, let us at Ovation help you.

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