Roth IRAs for the rest of us

By now you may have heard the story of Peter Thiel, the entrepreneur and venture capitalist who recently made headlines for having a Roth IRA allegedly worth $5 billion. The investigative web site ProPublica reported that Thiel funded his Roth with shares of PayPal – a company he helped create – back when its startup shares were valued at a fraction of a cent each.

If true, Mr. Thiel is looking at a lifetime of big withdrawals, if and whenever he chooses to make them, all completely free of income tax.

That’s what makes Roth IRAs so attractive. And it probably makes sense for you to consider having one, even if you’re not a multibillionaire.

Here are some of the reasons why:

• Tax-free compounding. There is no tax deduction for contributing to a Roth IRA, so it won’t help you on this year’s income taxes. But if you can be patient, your money has the potential to grow inside the account – for as long as you choose to leave it there – with no tax consequences.
• You can withdraw contributions at any time. Not that it’s wise to give up tax-free compounding, but you can access whatever you contribute without taxes or penalties whenever you choose.
• Tax-free withdrawals. Once you reach age 59½, providing your Roth IRA has been open for at least five years, you can withdraw both contributions and earnings tax-free. That’s what’s known as a qualified distribution. If your distribution is non-qualified, you’ll be subject to taxes and a 10% penalty on the earnings.
• No RMDs. Most tax-deferred retirement savings plans, including traditional IRAs and 401(k)s, require annual withdrawals, some or all of which is subject to income tax. Unless you inherited your Roth IRA as a non-spouse beneficiary, there is no required minimum distribution.
• Distributions don’t impact Social Security benefits. Above certain income levels, a portion of Social Security benefits become taxable. Distributions from Roth IRAs are not counted as income for this calculation.
• They are also Medicare-friendly. Medicare Part B and Part D premiums get more expensive at higher income levels, but again, Roth IRA distributions are not considered income for this purpose. But be careful when converting traditional IRA dollars to a Roth IRA: the conversion amount will increase your income in the year you do it.

Anyone with earned income (and non-working spouses) can contribute up to $6,000 per year to a Roth IRA. And once you reach age 50, the annual limit increases to $7,000. Total Roth contributions cannot exceed your earned income, however.

Eligibility also begins to phase out at certain income levels. Single taxpayers can make full Roth IRA contributions as long as their annual modified annual gross income does not exceed $125,000. An MAGI above $140,000 means no Roth contributions are allowed. If your income is between $125,000 and $140,000 partial contributions are allowed. For married couples filing jointly, the phaseout occurs at income levels between $198,000 and $208,000.¹

Rumors circulate from time to time that Congress might make it tougher to contribute to Roth IRAs. And the possibility that ultra-wealthy investors like Mr. Thiel have found a way to game the system could increase that possibility.

All the more reason to see if they make sense for you sooner rather than later.

¹ Eligibility requirements based on 2021 tax year and are subject to change in future years.

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