[MUSIC PLAYING]

Andrea Luengo:

Individual retirement accounts, or IRAs, are popular tools to help you save for retirement. Two of the most popular are traditional and Roth IRAs. In this video, we will focus on Roth accounts. So what are Roth IRAs, and why would you choose one?

Both the Roth and traditional accounts can be used to earmark money for the future. They allow you to invest your contributions in a variety of assets, and they both offer tax advantages. The main difference between them is how those advantages are structured. With a Roth, you contribute after-tax dollars.

That is, you pay income tax now, before your money goes into the account. After you deposit the funds, you'll choose from a variety of investment options offered by your Roth provider, such as stocks, bonds, mutual funds, or ETFs. Any growth in those investments occurs tax free. When you withdraw the money during retirement, you won't pay any taxes — not on the principal and not on any dividends or capital gains that you've earned. A traditional IRA works the other way around. You deposit your money on a pre-tax basis. The funds grow tax deferred, and then you pay taxes when you withdraw the money.

If you're paying taxes either way, does it matter whether you do it now or later? Maybe. Your income tax rate is determined each year, largely by how much you earn. Since we employ a progressive tax system in the US, the more money you earn, the greater the percentage of your income will likely go to taxes.

If you anticipate earning more in the future, paying taxes today while you're subject to a lower tax rate could make sense. And if the government raises tax rates, which is always a possibility, you would also avoid that increase. Again, you pay zero taxes on qualified distributions made during retirement.

That's important because if you have a long investment time horizon, you have a chance to earn a lot of money on your initial investment. Of course, with tax advantages like that, there are some limitations. As of 2023, the maximum annual contribution is $6,500 or $7,500 if you're age 50 or older.

You must have earned income, such as wages, and your modified adjusted gross income must be under the annual threshold. For 2023, that threshold is $153,000 for single filers and $228,000 for married couples filing jointly.

Don't worry if your income exceeds these limits. You can still take advantage of a Roth IRA by using a strategy called the backdoor Roth. The name sounds a little suspicious, but it's perfectly legal and aboveboard. It involves making an after-tax contribution to a traditional IRA and then converting it to a Roth.

This strategy only works if you have no funds in traditional IRAs when implemented. Contributions can be withdrawn any time without taxes or penalties, but when it comes to withdrawing the earnings, there are some key rules to know.

If you withdraw account earnings before you turn age 59 and a half or you made your first contribution within the past five years, the withdrawal will be subject to income tax plus a 10% penalty.

There are a few exceptions to the early withdrawal rules. You can take up to $10,000 for the purchase of your first home or an unlimited amount if you become totally and permanently disabled. Importantly, there are no required minimum distributions.

This is different from traditional IRAs, which require distributions beginning at age 73. With a Roth, you can let the investments continue to grow over the course of your lifetime. This feature makes them a strong choice for those looking to pass wealth to future generations.

So to recap, when you place your money in a Roth IRA, you've already paid tax on it once it's there. The investments grow tax free.

If your income exceeds the eligibility requirements, you may still benefit from a Roth by using the backdoor Roth strategy. You can withdraw contributions at any time without tax or penalties. You can begin withdrawing earnings tax and penalty free at age 59 and a half. Some limited early withdrawals are permitted.

There is no restriction on how long you can leave the money there to grow during your lifetime. To find out if a Roth IRA is right for you, please consult your tax advisor or a Bessemer professional who can guide you through the process.

[MUSIC PLAYING]