While it looked as though the spread of Coronavirus was starting to slow down, the number of cases spiked again this month nationwide. Utah was not immune to this trend, and because the pandemic clobbered the stock market in March, many people are wondering what effect this new activity will have on their retirement plans now.
It can be understandably nerve-wracking to log into your accounts and see a smaller number than before, but it’s important that you don’t panic. One of the things people fear most in life is losing money. But here’s the irony: When we’re afraid of losing money, we tend to make emotional decisions that lead to us losing even more money. We pull out of investments when they’re on the decline. We try to time the market based on the latest stock trends. We stop making contributions that have multiple benefits on our long-term plans. And through this process, we add unnecessary risk to our portfolios.
Discuss your situation with a financial advisor, and continue to contribute to your retirement plans if you can. Volatility may cause you concern, but remember your long-term goals and stay the course, if possible.
Do you remember the goals you have for your retirement accounts? Now is the perfect time for a refresher.
Don’t panic! Contact the professionals at Rock House Financial to see how we can help.
What’s the Purpose of an IRA
At Rock House Financial, we help many clients choose the most appropriate account for their situation. For many people, that’s an Individual Retirement Account (IRA). (If you’re a small business owner, read our recent blog post: An IRA for Business Owners … And Other Financial Planning Perks.)
Both a Roth IRA and a Traditional IRA are tax-advantaged savings vehicles. And both allow you to save up to a combined total of $6,000 for 2019 and 2020 ($7,000 if you are 50 or older). Investments in both types of IRAs grow tax-free until you withdraw the funds. In other words, if you invest now and plan to retire in 25 years, you will not be taxed on any increases in your portfolio that accrue during that time.
Although the contribution amounts and tax-free portfolio increases are the same for both Roth and Traditional IRAs, the chief difference between them is when the tax advantages occur.
Traditional IRAs are tax-deductible in the year of contribution. If you contribute $5,000 to a Traditional IRA in 2020, you can deduct the amount from your taxable income for the year. This can save you on taxes for the year, and may put you in a lower tax bracket.
Contributions to a Roth IRA, on the other hand, are not tax-deductible in the year of contribution. The contributions are made with income that has already been taxed.
In exchange, though, the withdrawals are not taxed when you make them in retirement, as long as you have held the Roth IRA for at least five years. Withdrawals from a Traditional IRA will be taxed at your ordinary tax rate when you make them.
These differences can alter your retirement income greatly – tax planning can benefit you both now and in retirement. If you want to tax-shelter your income in retirement, it may be advisable to invest in Roth IRAs so your withdrawals will not be taxed later. But if you’re more interested in a tax deduction now, it may be advisable to contribute to a Traditional IRA, so your higher income receives the tax deduction.
It’s always wise to discuss IRA pros and cons with a financial advisor who understands your complete financial situation.
Roth IRA Contributions are also Subject to Income Limits
Investors should understand that Roth IRAs are subject to income limits, while Traditional IRAs are not.
If you are married and filing tax returns jointly, you can contribute up to the full amount as long as your income is less than $196,000. If your income is between $196,000 and $205,999, the contribution the Internal Revenue Service (IRS) allows is reduced. If your income is more than $206,000, you’re not eligible for a Roth IRA.
The Benefits of a Roth IRA
Now that we’ve mapped out the differences between Roth and Traditional IRAs, let’s look at the IRA pros and cons. There are many benefits to a Roth IRA that a Traditional IRA doesn’t offer.
1. Your Earnings are Always Tax-Free
Once you know that the earnings on Roth IRAs grow tax-free and that you won’t be taxed at retirement, it’s clear that your earnings will always be tax-free. But it’s worth reiterating just so folks understand what a benefit that is.
If you’ve had a portfolio of Roth IRAs for 30 years and the earnings have amounted to $300,000 over time, none of it will ever be subject to taxation.
If you have the same accrual in a Traditional IRA, the earnings will be taxed at your ordinary rate as you withdraw them.
2. Early Withdrawals Can Be Much More Flexible
Both types of IRAs can be withdrawn for retirement starting at the age of 59-½. If you take withdrawals before that, they are subject to a 10 percent tax penalty for early withdrawal. While there are exceptions to this rule this year because of the pandemic, taking an early withdrawal from your retirement accounts should be a last-resort decision. Read our recent blog post: What an Early Withdrawal from Your Retirement Fund Really Means.
The IRS also allows early withdrawals from Roth IRA accounts you’ve held for less than five years without the 10 percent penalty if you are at least 59-½ and withdrawing the money for certain specified purposes. These are:
- A disability
- Specific financial hardship
- A first-home purchase, qualified educational costs or specific medical costs
- An estate or beneficiary withdrawal after your death
3. You Never Have to Take RMDs
Retirees must take Required Minimum Distributions (RMDs) from Traditional IRAs (as well as both Traditional and Roth 401(k)s) once they meet a certain age. Tax penalties for failing to take your RMDs can equal 50 percent of the amount that should have been distributed.
However, Roth IRAs are never subject to RMDs, making them one of the few retirement savings methods that allows you to take withdrawals or save, as you prefer. This opens Roth IRA savings to several strategies, including keeping them until later in life as a nest egg or hedge against a costly health emergency or retirement need, such as a nursing home or assisted living.
It’s wise to discuss your options with a financial advisor you trust before making a decision that can have long-term effects on your finances.
4. You Can Pass Roth IRA Accounts Tax-Free to Your Beneficiaries
Roth IRAs can also make estate planning easier, because you can bequeath Roth IRAs to your estate or the beneficiaries in your will, and the money will pass to them tax-free. In other words, if you intend to leave a beneficiary $150,000, they receive all of it.
If you bequeath funds from a Traditional IRA, on the other hand, it will be subject to tax, which the beneficiaries must pay.
Bottom Line
There are a lot of benefits to your retirement plan contributions – for you and for your heirs. Remember your long-term plan. There’s a lot of uncertainty in the world today, so try to focus on what you can control.
If you’re still worried about your retirement plans, review their activity in 2008 and 2009 and see what happened then. Discuss your plan with your financial advisor. Emotional decisions can lead to financial mistakes that can have long-term effects on your future. If you’re losing sleep at night, discuss your risk tolerance with your financial advisor to see if it’s still appropriate.
