With millions enduring furloughs and salary cuts, more people may be eligible for a Roth IRA in 2020.
THERE’S NOT MUCH GOOD news in today’s coronavirus-induced economic calamity, between mass layoffs, furloughs and salary reductions, temporary or otherwise. Millions of Americans are likely to end the year with a reduced income. But a crisis sometimes offers opportunities. For those who are financially able, a low income year offers a unique option to save in a Roth IRA and pay a low tax rate on your contributions.
Here are the major advantages of contributing to a Roth IRA in a low-income year:
- You must earn below certain income limits to qualify to contribute to a Roth IRA.
- You may be in a lower tax bracket because of a loss of income and pay less tax on your contributions.
- When the market is down, you can buy into funds at lower prices and watch them grow tax-free.
Roth IRA Eligibility
You can contribute up to $6,000 to a Roth IRA in 2020, or $7,000 if you are 50 or older. However, there are income limits on who is allowed to contribute to a Roth IRA. If you are single, you can contribute the full amount to a Roth IRA if you earn up $124,000 and make a partial contribution if you earn between $124,000 and $139,000. Earnings above $139,000 as an individual make you ineligible to contribute to a Roth IRA in 2020. For couples who are married filing jointly, the ability to make a Roth IRA contribution is phased out for couples earning between $196,000 and $206,000. These income limits only apply to Roth IRAs, not company-sponsored Roth 401(k)s.
Many people who would be ineligible for a Roth IRA in previous years might qualify today. If you were laid off, furloughed or took a pay cut, you will very likely earn less in 2020 than you did in 2019. “We advise everyone under the income limit to seriously consider contributing,” says Greg Dillon, principal of OneTeam Financial, which has offices in Red Bank and Cranford, New Jersey.
However, you might want to delay your contribution if you expect to encounter financial hardship this year. “Given all of the uncertainty as far as employment for the remainder of year, first make sure you have an adequate cash cushion,” Dillon says. “In some instances, folks don’t know if they will be out of work for a few months or longer. You want to make sure they have enough for the tax bill and to pay bills if they don’t get back to work in short order.”
Roth IRA Taxes
With a traditional IRA, you don’t pay taxes on the money you deposit, but withdrawals are taxed as ordinary income. You deposit money on which you’ve already paid taxes in a Roth IRA, and then the money you withdraw in retirement is not taxable. A Roth IRA conversion means you pay tax on your savings in the year you move your money from the traditional IRA to the Roth in order to set up tax-free income later in life. Your Roth IRA will eventually be a tax-free source of retirement income.
When deciding between a traditional and Roth IRA, it can be helpful to compare your current tax rate to what you expect your future tax rate to be in retirement. Then you can make an educated guess about whether to pay the taxes now using a Roth IRA or delay taxes until retirement using a traditional IRA. “Income may be lower in retirement, but that doesn’t mean your tax rate or tax bill will be,” Dillon says. “That’s something people have to consider when they think about pre-tax and funding a Roth.”
If you have an unusually low income this year, you could drop into a lower tax bracket and pay a low tax rate on your Roth IRA contributions. If you are normally in the 24% tax bracket, but drop into the 12% tax bracket in 2020, you will pay half your usual tax rate on your Roth IRA contribution. It makes the most sense to open a new Roth IRA or convert your traditional IRA to a Roth if you think you will be in a higher tax bracket in the future than you are now, says Ken Moraif, a senior advisor at Retirement Planners of America in Dallas, Texas. He says you should think about a Roth contribution especially if you are in the lower tax brackets such as the 12% or 22% tax rates.
Buying Low in a Roth IRA
You can buy into funds at lower prices while the stock market is down. If you invest within a Roth IRA your money will grow tax-free and you won’t have to pay tax on any of the investment earnings. “Money invested (in a Roth IRA) may be invested differently than money you may need a few years from now,” Dillon says. “Make sure your investments are more growth-oriented. Then you are capitalizing on that tax-free compounding.”