Roth IRAs – “these are a few of my favorite things!” 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 in retirement.
What is a Roth IRA?
A Roth IRA is an individual retirement account that offers favorable tax-free growth and tax-free withdrawals in retirement, subject to rules – we’ll get to those! Roth IRA contributions are deposited with after-tax dollars, vs. Traditional IRA contributions that ‘can be’ tax deductible.
If you contribute to a Roth IRA, it’s like buying apple seeds (paying tax) and planting them in the ground. Decades go by and you are now ready to retire. 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 you must pay taxes on every single apple you pick from the trees in retirement. Do you want to pay taxes on the seeds or on the apples?
4 Ways to Contribute to a Roth IRA
- Direct After-Tax Cash 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 – this means that you must earn wages to contribute to an IRA. In the case of a married couple with only one income earner, both spouses can contribute to his/her separate account if earned income is sufficient to cover both contributions. Eligibility to contribute directly to a Roth IRA is subject to income limits; modified adjusted gross income (MAGI) must be under $139,000 if a single filer or under $206,000 if married filing jointly, with additional reduction thresholds. Keep in mind that direct IRA contributions can be made until April 15th (tax date) of the following year – this means that you could contribute for year 2020 until April 15, 2021. Pretty sweet!
- 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 move the assets (in cash or in-kind) into a Roth IRA, paying income tax on the conversion amount that year. The taxes owed on the converted amount are usually paid with after-tax dollars from outside of the conversion itself – this allows more assets to be converted and grow tax free. Unlike direct contributions, conversions do not have contribution limits – just be sure you can cover the tax liability on the conversion amount!
- Backdoor Roth Conversions (Non-Taxable): A backdoor Roth conversion means that you take after-tax, non-deductible contributions from an existing tax-deferred account (like a Traditional IRA) and move them into a Roth IRA, owing no taxes on the conversion amount as long as there are no earnings being converted. This method is popular for people who cannot contribute directly to a Roth IRA due to high income above the limits; they will instead make a direct, non-deductible contribution to a Traditional IRA and quickly convert it to the Roth IRA. Consult a tax professional when considering this method, as there may be unintended tax consequences.
- Direct Roth Rollover (Non-Taxable): You can transfer other Roth accounts such as Roth 401(k)s into your Roth IRA, and pay no taxes if it is 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 you are still employed where the plan is provided, and can have other unintended consequences if you are unemployed. Measure twice and consult a professional before moving these assets.
4 Ways to Withdraw from a Roth IRA (Order of Operations)
- Contributions First: You can take your direct Roth IRA contributions (#1 above) back at any time for any reason, without owing income taxes or a 10% penalty.
- Taxed Conversions: If you want to withdraw money that was part of a taxed 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 taxed 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.
- Non-Taxed Conversions: If you initiated a non-taxable conversion (#3 above) or rollover (#4 above) into your Roth IRA, you can withdraw the conversion or rollover amounts at any time for any reason, without owing income taxes or a 10% penalty.
- 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 qualified higher education expenses, paying medical premiums while unemployed or medical expenses in excess of 7.5% AGI, or paying an IRS levy.
Your distribution of earnings will only be completely tax and penalty free if your first Roth IRA was open/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).
What else should I know?
Now that your head is spinning from the tricky withdrawal rules, I’ll 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.
- Roth IRAs have the incredible benefit of providing cash flow flexibility in retirement. Let’s 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 you have to distribute $50,000 and withhold 20% for 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 request “in-plan Roth conversions” – this is a way to convert pre-tax assets (including the vested employer contributions) to Roth within the plan. You need to 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 qualified accounts, 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 access to your retirement assets early. It is best to have enough savings and after-tax brokerage assets to cover living expenses and conversion taxes during the first 5+ years. These conversions can even be done without paying any taxes, if carefully calculated.
I hope you know more about Roth IRAs than you did yesterday and can find ways to integrate these concepts into your own retirement planning. Don’t hesitate to consult a professional before making these decisions, as the details can be difficult to maneuver. Keep learning and improving your plan on the way to financial independence!