Roth IRAs: Know the Facts!

As we start 2021, we can reevaluate and anticipate our financial objectives, income assumptions, and tax-efficient savings opportunities for the new year. Whether you are actively employed and accumulating assets or distributing income in retirement, a Roth IRA can play a major role in your financial plan. Roth IRAs are becoming more popular as investment vehicles, and for good reason! These accounts can provide incredible growth potential, cash flow flexibility, and favorable tax treatment to and through retirement. If you want to demystify Roth IRA contributions, conversions, rollovers, and distributions, let us dig into the facts!

What is a Roth IRA?

A Roth IRA is an individual retirement account that can offer favorable tax-free growth and tax-free withdrawals in retirement, subject to rules – we will get to those! Roth IRA contributions are deposited with after-tax dollars, vs. Traditional IRA contributions that may be tax deductible.

If you contribute to a Roth IRA, it is similar to buying apple seeds (paying tax) and planting them in the ground. Decades go by and you are now ready to reap what you sowed. The seeds have grown into an apple orchard, and every apple you pick from the trees is tax-free (no sharing). If you instead make a tax-deductible contribution to a Traditional IRA, you pay no taxes on the seeds BUT every apple you pick from the trees in retirement is taxable as ordinary income – the IRS may take a bite!

4 Ways to Contribute to a Roth IRA

  1. Direct After-Tax Contributions: A direct, non-deductible contribution of cash can be made into a Roth IRA. You can contribute the lesser of $6,000 ($7,000 if age 50 or older) or earned income to your combined IRAs (Traditional and Roth) for year 2021. This means that you must have earned compensation to contribute to an IRA, including sources such as wages, salaries, tips, bonuses, and net self-employment income. Earnings from rental, interest, and dividend income, and pension/annuity income are not included in compensation. In the case of a married couple (filing jointly) with only one income earner, both spouses can contribute to his/her separate account if the earned income is sufficient to cover both contributions. Eligibility to directly contribute to a Roth IRA is subject to income limits; modified adjusted gross income (MAGI) must be under $140,000 if a single filer or under $208,000 if married filing jointly, with additional reduction limits. Keep in mind that IRA contributions can be made until April 15th (tax filing date without extensions) of the following yearDue to a unique extension for tax year 2020, you may still be able to contribute until May 17, 2021!
  2. Roth Conversions (Taxable): A Roth conversion means that you take all or part of an existing pre-tax retirement account (like a Traditional IRA) and transfer the assets to a Roth IRA. The converted amount is included as taxable income in the year of conversion, so this is a taxable event. It is usually best to elect 0% tax withholding on the Roth conversion itself and pay any additional tax liability from withholding or estimated tax payments; this allows more Roth assets to grow tax-free and avoids the 10% early withdrawal penalty if younger than age 59 1/2 . Unlike direct contributions, Roth conversions do not have income limits nor restrictions on the converted amounts – just be sure you can cover the tax liability on the converted amounts!
  3. Backdoor Roth Conversions (Potentially Non-Taxable): A backdoor Roth conversion means that you take after-taxnon-deductible balances from an existing pre-tax account (like a Traditional, SEP, or SIMPLE IRA) and move them into a Roth IRA, owing no taxes on the conversion as long as there are no pre-tax contributions or earnings in the account. If your tax-deferred IRA balances contain pretax and after-tax amounts, a conversion will include a pro rata share of both. Backdoor Roth IRA conversions are valuable for individuals who cannot directly contribute to a Roth IRA due to household income above the limits. Consult a financial professional when considering this method, as there may be unintended tax consequences.
  4. Direct Roth Rollover (Non-Taxable): You can transfer other Roth accounts such as Roth 401(k)s into your Roth IRA without a taxable event if initiated as a direct rollover – this means that the money goes directly from one account to the other, without the funds touching your hands. These rollovers are subject to retirement plan rules (in-service distributions). If your employer contributes to your retirement plan, those pre-tax contributions and earnings should be transferred to a Traditional IRA unless you also intend to initiate a taxable conversion. Measure twice to ensure your rollover is truly aligned with your intention.

4 Ways to Withdraw from a Roth IRA (Order of Operations)

  1. Contributions First: You can withdraw your direct Roth IRA contributions (#1 above) at any time for any reason without owing income taxes or a 10% penalty.
  2. Taxable Conversions: If you want to withdraw money that was part of a taxable Roth conversion (#2 above), you will owe a 10% penalty UNLESS you are over age 59 1/2 OR if more than 5 years has passed since the conversion. This means that each taxable Roth conversion must sit in your Roth IRA for 5 full years before you can withdraw the converted amount penalty-free if you are under age 59 1/2. Once you turn 59 1/2, this penalty will go away on the converted amount.
  3. Non-Taxable Conversions: If you initiated a non-taxable Roth conversion (#3 above) or rollover (#4 above) into your Roth IRA, you can withdraw those conversion and rollover amounts (not earnings) at any time for any reason without owing income taxes or a 10% penalty.
  4. Distributions of Earnings: If you want to distribute earnings (beyond your contributions and conversions) from a Roth IRA, pay close attention to the following rules:

    You will owe income taxes but no 10% penalty if the Roth IRA was open for less than 5 years and you are over age 59 1/2, dead, totally disabled, taking substantial equal periodic payments (SEPP), using for a ‘first’ home purchase ($10k max), paying for birth or adoption expenses ($5k max), paying for qualified higher education expenses, paying medical premiums while unemployed or medical expenses in excess of 7.5% AGI, or paying an IRS levy. Whew!

    Your distribution of earnings will only be completely tax and penalty-free if your first Roth IRA was open and funded for more than 5 years and you are over age 59 1/2, dead, totally disabled, or using for a ‘first’ home purchase ($10k max), etc.

What else should I know?

Now that your head is spinning from the tricky withdrawal rules, I will slow down and share last thoughts:

  • The decision to contribute to a Roth IRA should not solely be contingent upon your current income tax rate and your assumption of future tax rates. If you choose instead to contribute to a Traditional IRA and take the tax deduction, be sure to make a plan for how that income will be distributed and fully taxable in retirement. Here are the advantages and disadvantages of both options.
  • Roth IRAs have the incredible benefit of providing cash flow flexibility in retirement. Imagine that you only have pre-tax retirement accounts and you want to take an incredible trip with your family to celebrate your first year in retirement. The trip costs $40,000, but may you have to distribute $50,000 gross and withhold 20% for federal income taxes. This taxable distribution may also push you into a higher marginal tax bracket, increase your Medicare premiums, increase taxation of Social Security benefits, or limit future growth in your IRA. If you instead used a Roth IRA to pay for this trip, you would only need to distribute $40,000 and avoid the other potential consequences. Diversifying across different tax locations including Roth IRAs and taxable brokerage accounts can provide future flexibility.
  • If you have both pre-tax and Roth options in your employer’s retirement plan, you may also have the option to initiate “in-plan Roth conversions” – this is a way to convert pre-tax assets (including the vested employer contributions) to Roth within the plan. You should pay the taxes from outside of the conversion by adjusting your W-4 withholding or making estimated tax payments.
  • Roth Conversion Ladder: Since we learned about taxable conversions and the 5-year conversion clock, we can use this technique in the case of early retirement. Retiring before age 59 1/2 limits the ability to take distributions from most retirement accounts without penalty, but if you convert assets from pre-tax to Roth IRAs in early retirement when your income drops, you can start the 5-year clocks on these conversions each year to slowly gain penalty-free access to your retirement assets. It is best to have enough after-tax savings to cover living expenses and conversion taxes during the first 5+ years.

I hope you know more about Roth IRAs than you did yesterday and can find ways to integrate these concepts into your own retirement plan. Do not hesitate to consult a financial professional before making these decisions, as the details can be difficult to maneuver. Keep learning and improving your plan along your path to financial independence!

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