By: Alexandra Stewart, CFP®
Roth IRAs offer enticing incentives to savers. Growth accumulates tax-free, withdrawals in retirement can be made tax-free, and you can take out your contributions at any time tax-free and penalty-free. We like tax-free, and we like growth. Together, they make a powerful combination.
Consider a young professional who contributes the maximum $6,000 annually for just 10 years before success in their career pushes their income to a level that makes them ineligible for Roth contributions. If our hero achieves an eight percent average annual return on their cumulative investment ($500 a month for 10 years), they would amass over $1,285,000 by age 67... Tax free! Nice!
If that got your attention, you’ll need to meet the eligibility requirements to contribute to a Roth: (1) You or your spouse must have earned income, and (2) your Modified Adjusted Gross Income must be under certain limits, as shown in the graphic below.
For 2019, single taxpayers with modified adjusted gross income of up to $122,000 may contribute up to $6,000 of earned income ($7,000 if they are 50 or older). At higher earnings levels, the allowable contribution is reduced until it is eliminated entirely when income reaches $137,000. For couples those eligibility limits are higher, and each may contribute up to $6,000 of their combined earned income ($7,000 if they are 50 or older).
This works particularly well for those in lower tax brackets. While there isn’t a tax deduction for your contribution, you aren’t giving up much of a front end tax break if your income places in some of the lower tax brackets. The U.S. has a progressive tax system. The first portion of your earnings up to the standard deduction is tax-free. Amounts over that, are taxed at progressively higher rates. First you fill up the 10% bracket, then the 12%, 22%, and 24% brackets before reaching the current eligibility limit for Roth IRA contributions.
The breakpoints for these brackets are lower for singles than they are for couples. Obviously, forgoing the up front tax break in the 0%, 10%, or 12% brackets isn’t that much of a sacrifice. If you are a super saver and also contribute to your pre-tax retirement plan at work, it may make sense to consider how much of a pre-tax contribution to make in order to keep you out of the higher brackets, and then focus your firepower on the Roth IRA. A little bit of planning close to these breakpoints can make the best use of those opportunities.
If this sounds like a fit for someone you know, be sure to introduce them to us before April 15th, 2020, the contribution deadline for tax year 2019.