With Christmas in the rearview window, the Cutter family leapt into 2020 with renewed energy and enthusiasm. For Sophie and Phoebe, this included heading back to the Braintree Mall for yet another shopping trip. This trip meant spending some of the money they received from their grandparents as Christmas gifts. Phoebe also wanted to return a book she bought for Sophie. It turns out Sophie had already read it and would rather use that 25 bucks for a sweater she had her eye on at a different store.
Unfortunately, after waiting in line for 20 minutes to get a refund, the girls were told that since the book was purchased on clearance, they would get store credit instead of cash back. Needless to say, they were not happy. While it was still a $25 credit, it wasn’t that lovely pink sweater that Sophie really wanted. Phoebe, for her part, was kicking herself for not paying attention to the signs in the clearance section that said, “No returns — store credit only.” They learned the hard way that it pays to read the fine print before making a decision.
You know, this got me thinking.
I got thinking about how the same forethought and product knowledge is true when you’re planning for retirement. Would you buy a car without considering resale value? Or purchase a low-priced airline ticket that has high change fees? The answer may still be yes to both questions, but hopefully it’s because you considered those back-end limitations and the purchase was still worth it, or you have a contingency plan.
And as we prepare for retirement, we need to be just as cautious about the fine print. One particular example of this is Roth IRA distributions. I find that very few people think of taking anything other than tax-qualified distributions when they invest into a Roth IRA. That is because folks usually focus on the 100% tax-free nature of those distributions or withdrawals. However, it’s still very important to be aware of the ramifications of taking a non-tax-qualified distribution from a Roth IRA. So, this week, let’s dig into some facts you need to consider if you’re thinking about adding a Roth IRA to your retirement income strategy.
First, some backdrop. The Roth IRA was established by the Taxpayer Relief Act of 1997 and named for its chief legislative sponsor, Sen. William Roth of Delaware. It’s an individual retirement account (IRA), and the IRS mandates specific eligibility and filing status requirements. Some of its most significant advantages are its tax structure and the additional flexibility that this tax structure provides.
Unfortunately, not everyone can contribute to a Roth IRA. Your tax filing status and adjusted gross income determine whether you can contribute. Your income has to fall below certain amounts set by the IRS, referred to as your modified adjusted gross income (MAGI). Furthermore, you must have “earned income” in order to contribute. This includes money from wages, salaries, tips, bonuses, commissions, and self-employment income.
Contributions made to a Roth IRA are not tax-deductible, but they instead offer tax-free (qualified) distributions, which can be a significant boon to a retiree’s income plan. Unlike traditional IRAs, Roth IRAs aren’t subject to required minimum distributions, so your money has more time to grow … tax-free.
But it’s important to be aware of the difference between a tax-qualified distribution and a non-tax-qualified distribution so that you can make an informed decision about whether a Roth makes sense for you. A Roth IRA distribution (or withdrawal) is generally considered to be tax-qualified — and therefore tax-free — if you’re age 59 1/2 or older and the account has been open for at least five years. You can also receive tax-free income by taking withdrawals as a series of equal periodic payments. A Roth also gives you the ability to take a tax-free withdrawal of up to $10,000 for the purchase of your first home.
It’s also important to note that qualified distributions from a Roth aren’t included in your gross income. That means you won’t owe taxes or penalties on the withdrawals, and they won’t be counted as part of your income when it comes to calculating taxes on your Social Security benefits. This is different from traditional IRA distributions, which are included in your gross income for tax purposes.
Now that we’ve reviewed what a qualified distribution looks like, let’s look at what a non-qualified distribution from a Roth IRA is and how it affects your retirement income plan. Generally speaking, a non-qualified distribution is anything that deviates from the IRS guidelines for a tax-qualified distribution — which means that the distribution is taken prior to your age 59 1/2, it doesn’t meet the guideline of five years since initiated, or it doesn’t qualify for one of the exceptions.
Non-qualified distributions from a Roth IRA are subject to ordinary income tax on any earnings as well as an additional 10% federal tax penalty. The goal here is to encourage savers to preserve their retirement accounts for retirement and not tap into them early for non-retirement needs. And while you can’t necessarily predict every situation that might crop up in retirement, you should at least think about some possibilities when you’re considering the Roth IRA. For instance, if you’re planning to retire at age 55 and there’s even a chance you might need income from the account before age 59 1/2, you should reconsider if the Roth is right for your situation. Or, let’s say you don’t have a healthy emergency fund. If you need a new roof or new car, will you need to tap into the Roth for this? It’s these types of scenarios you should consider as you evaluate a Roth IRA or any other retirement savings option.
A Roth IRA can be a powerful retirement income tool, and for many people, the tax-free income it provides is a tremendous advantage — but you need to understand the ins and outs of it before you decide if it’s right for you. Like Phoebe, you need to read the fine print to determine if it’s the great deal you’ve been looking for or if the terms are too expensive for your tastes.
So as always, be vigilant and stay alert, because you deserve more!
Folks, have a great week.
Jeff Cutter, CPA/PFS is president of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, and Mansfield, Massachusetts, and Southlake, Texas. Jeff can be reached at firstname.lastname@example.org.
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