If you’re investing for retirement, the Roth IRA is a sometimes overlooked option worth considering. Unlike your TSP, investments in a Roth IRA are not deductible from current income. But like your TSP, the earnings in your account are allowed to compound tax-free. And here’s the best part: when you begin withdrawing money from your Roth IRA in retirement, you won’t owe taxes on any of it!
That’s a powerful retirement-savings boost. To understand just how powerful, let’s look at the hypothetical example of a 35-year-old investor who begins investing $250 per month in a Roth IRA —and continues doing so until retiring at age 60*.
Total investing years: 25
Assumed annual rate of return: 8%
Monthly investment: $250
Total amount invested: $75,000
Total amount accumulated: $228,750
*This is a hypothetical investment for illustration purposes only and is not a guarantee of past or future performance.
In this case, our investor realized total earnings of $153,750—and owes taxes on none of it. In fact, even if the money continues to grow after retirement, there will still be no taxes due. So, if tax-free retirement income appeals to you, a Roth IRA might be the right investment.
Are there situations in which a Roth IRA might not be the best choice? Absolutely. If you are a FERS employee, your TSP includes matching contributions. You should always contribute the full amount that qualifies for matching. It never makes sense to turn down free money! But, the TSP only matches the first five percent of contributions—and most employees need to invest more than that to achieve their retirement objectives. So if you plan to contribute more than the amount that qualifies for matching, a Roth IRA might still be an option.
A Roth IRA isn’t the best choice for investors concerned about lowering their current tax bill either. They can reduce their taxable income by investing pre-tax dollars in the TSP or, if their income falls below the IRS-specified minimum amounts, in a Traditional IRA. But think carefully about whether you would rather defer taxes on your retirement accounts until retirement – or whether you prefer to pay those taxes during your working years so that you don’t have to deal with them in retirement.
Finally, the government will soon offer a relatively new breed of retirement savings plan – the TSP Roth 401(k). These plans offer benefits identical to Roth IRAs, but with considerably higher contribution limits. So, when the TSP Roth 401(k) is available, you may prefer the convenience of having all of your retirement investments deducted directly from your paycheck. Just keep in mind that you can choose from a wider array of investment options within a Roth IRA.
So how does a Roth IRA work? At first glance the rules are pretty straightforward. To be eligible to contribute, you must have earned income. But not too much – if your adjusted gross income (AGI) exceeds IRS-specified income limits, you cannot contribute to a Roth IRA. These limits vary depending on your filing status.
How much can you invest in a Roth IRA? The current maximum annual contribution for those under age 50 is $5,000. But to help workers age 50 and over prepare for their impending retirement, the IRS has a subset of rules that allow these workers to make “catch-up contributions” of up to $1,000 per year.
Let’s review the rules governing distributions, or withdrawals, from a Roth IRA. There are two forms of distributions—qualified distributions and early distributions. A qualified distribution is one that occurs when the IRA owner is at least 59 ½ years old and at least five years after the account was established. There are no taxes on qualified distributions.
Early distributions are those made prior to age 59 ½, or before the account has been in place for five years. Early distributions are subject to a 10% tax penalty—with exceptions made for first-time homebuyers, qualified education expenses and disability.
Think a Roth IRA sounds right for you, but not sure where to find the money to fund your account? Consider investing your tax refund. The IRS estimates that about 70% of taxpayers get refunds, and last year the average check totaled $2,348. That cash would make a great start to your Roth IRA. But, no matter how you get started, the earlier the better to allow many years of compounding….tax free!
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