The Roth IRA
Who wouldn’t want tax free income after the age of 59.5? There are plenty of reasons a tax-free source of cash in retirement can be part of an overall strategy to minimize taxes and increase available dollars for spending. In this post, we won’t get too deep into those strategies. Instead, this is a primer on the Roth IRA so as you read about strategies elsewhere, you can conceptualize how those strategies work and how they would play out in your financial plan.
What is a Roth IRA?
When it comes to saving for retirement, there are basically three types of investment accounts from a tax standpoint: pre-tax (i.e. IRA, 401k, Simple IRA, 403b); a Roth IRA; and a taxable brokerage account. A Roth IRA allows investors to place post tax dollars (dollars they’ve already paid income tax on) into a tax deferred IRA savings account. Tax deferred means that as your investments earn income or grow, you don’t pay any tax on them. The beauty of a Roth IRA is that once you turn 59.5 years of age AND you’ve had a Roth account for 5 years, the funds in that account can be withdrawn tax and penalty free.
There are three ways funds can end up in a Roth IRA account: contributions, conversions, and earnings. It’s important to understand the difference between each one of these sources of funds because each has their own rules for both entering the account and bei
ng taken out of the account.
Contributions
Contributions are made to a Roth IRA account on a tax year basis. If a taxpayer meets the income limits for contributing and has earned income to support the contribution they can contribute up to the maximum for that year. Each year the IRS sets a limit on the amount of a person can contribute to their Roth IRA.
Contribution Rules for a Roth IRA
For 2024 the maximum amount a taxpayer can contribute to a Roth IRA is $7,000. Individuals age 50 and older can contribute $8,000[1]. To qualify for these contribution limits, however, the taxpayer would have to have had earned income to the extent of the contribution (so if their earned income was only $3,000 for the year they would be limited to a $3,000 contribution). The individual would also have to have not had income for the year beyond the income thresholds for that tax year. For 2024 those thresholds looked like this[2]:
| If your filing status is… | And your modified AGI is… | Then you can contribute… |
| married filing jointly or qualifying surviving spouse | < $230,000 | up to the limit |
| married filing jointly or qualifying surviving spouse | > $230,000 but < $240,000 | a reduced amount |
| married filing jointly or qualifying surviving spouse | > $240,000 | zero |
| married filing separately and you lived with your spouse at any time during the year | < $10,000 | a reduced amount |
| married filing separately and you lived with your spouse at any time during the year | > $10,000 | zero |
| single, head of household, or married filing separately and you did not live with your spouse at any time during the year | < $146,000 | up to the limit |
| single, head of household, or married filing separately and you did not live with your spouse at any time during the year | > $146,000 but < $161,000 | a reduced amount |
| single, head of household, or married filing separa
tely and you did not live with your spouse at any time during the year |
> $161,000 | zero |
You’ll notice in the chart that the income limits are based on MAGI (modified adjusted gross income). Each time MAGI is used in the tax code, MAGI is calculated in a different way, but always starts with AGI (adjusted gross income) and then adds some things back in like IRA contributions, student loan interest, tax-deductible interest for example. Here is the calculation for MAGI for Roth IRA contributions:
Worksheet 2-1. Modified Adjusted Gross Income for Roth IRA Purposes[3]
| Use this worksheet to figure your modified adjusted gross income for Roth IRA purposes
. |
| 1. | Enter your adjusted gross income from Form 1040, 1040-SR, or 1040-NR, line 11 | 1. | _____ |
| 2. | Enter any income resulting from the conversion of an IRA (other than a Roth IRA) to a Roth IRA (included on Form 1040, 1040-SR, or 1040-NR, line 4b) and a rollover from a qualified retirement plan to a Roth IRA (included on Form 1040, 1040-SR, or 1040-NR, line 5b) | 2. | _____ |
| 3. | Subtract line 2 from line 1 | 3. | _____ |
| 4. | Enter any traditional IRA deduction from Schedule 1 (Form 1040), line 20 | 4. | _____ |
| 5. | Enter any student loan interest deduction from Schedule 1 (Form 1040), line 21 | 5. | _____ |
| 6. | Enter any foreign earned income exclusion and/or housing exclusion from Form 2555, line 45 | 6. | _____ |
| 7. | Enter any foreign housing deduction from Form 2555, line 50 | 7. | _____ |
| 8. | Enter any excludable qualified savings bond interest from Form 8815, line 14 | 8. | _____ |
| 9. | Enter any excluded employer-provided adoption benefits from Form 8839, line 28 | 9. | _____ |
| 10. | Add the amounts on lines 3 through 9 | 10. | _____ |
| 11. | Enter:
|
11. | _____ |
| Is the amount on line 10 more than the amount on line 11? If “Yes,” see the Note below. If “No,” the amount on line 10 is your modified adjusted gross income for Roth IRA purposes. |
|||
| Note. If the amount on line 10 is more than the amount on line 11 and you have other income or loss items, such as social security income or passive activity losses, that are subject to AGI-based phaseouts, you can refigure your AGI solely for the purpose of figuring your modified AGI for Roth IRA purposes. (If you receive social security benefits, use Worksheet 1 in Appendix B to refigure your AGI.) Then, go to line 3 above in this Worksheet 2-1 to refigure your modified AGI. If you don’t have other income or loss items subject to AGI-based phaseouts, your modified adjusted gross income for Roth IRA purposes
is the amount on line 10 above. |
|||
Once you’ve determined if you are within the income limits to contribute to a Roth IRA and have calculated what your annual contribution limit is according to your age and income level, you can make up to that amount as a contribution for that particular year. You have up until the deadline for taxes (April 15 of the following year). If you are allowed to contribute $5,000 based on your amount of earned income, your age or your income level, you can contribute that amount or anything less than that for that year. Once April 15 of the following year comes along you can no longer contribute for that previous year. You would then use the same rules to determine your contribution limit for the next year.
Conversions
Didn’t qualify for a contribution to a Roth IRA in a given year because your income was too high? There is still a way for you to get funds into a Roth IRA account: a Roth conversion. A Roth conversion involves moving money from a pre-tax retirement savings into a Roth IRA. Before those dollars can enter the Roth account, however, they need to be after-tax dollars.
Back Door Roth
A Back Door Roth involves an individual making a non-deductible contribution to an IRA (which anyone can do up to the contribution limit for their age and earned income amount). Because this would be after-tax dollars it can be moved (converted) into a Roth IRA account. One thing it’s important to take into consideration when doing a Back Door Roth, however, is the pro-rata rule. If the individual’s IRA accounts (all their IRA account are counted as one for this calculation) have pre-tax (deductible) contributions in them, the amount converted to a Roth IRA would be taxed according to the ratio of pre-tax and after-tax dollars.
Mega Back Door Roth
Another type of Roth conversion that allows higher income earners to get funds into a Roth IRA is a Mega Back Door Roth conversion. A Mega Back Door Roth is done with after-tax contributions to a 401k. Those after-tax contributions are then converted to a Roth 401k or to a Roth IRA. Not all employer’s 401k plans allow after-tax contributions or conversions, so check the plan details before proceeding. If allowed, the Mega Back Door Roth has the potential to convert much higher amount to Roth Funds due to the higher contribution limits in a 401k for after-tax dollars.
Whether using the Back Door Roth or a Mega Back Door Roth, the conversion can be maximized using two strategies: bracket-bumping and market-timing.
Bracket-bumping is a way of keeping lifetime income taxes low by only doing a conversion to the extent that there is room left in the taxpayer’s current marginal income tax bracket. If the individual is currently in the 22% marginal bracket for instance, you wouldn’t want to convert dollars that would bump them into the next higher bracket. In this way, conversion strategies are done slowly year after year. It is generally excepted that conversions make sense when you believe your tax rate will be higher when taking distributions than they are when doing the conversion. Higher tax rates could be due to higher income or changes in tax laws that raise tax rates.
Market-timing of conversions is done by having post tax dollars ready to convert once the market goes down. This way, you’ll be paying less tax on the amount converted. For instance, you max out a non-deductible contribution into an IRA at $7,000, let it sit in that account until the market takes a downturn. If the market had a 10% correction, you would now be converting $6,300 and paying tax on that amount instead of on $7,000. As the market comes back up those dollars are already post tax and can enjoy tax deferred growth and then will be tax free at the time of withdrawal once you reach age 59.5 and the five year clock is up. It is important to note that the deadline for Roth conversions is December 31st of that year and it is possible the market won’t have a correction before then. You could end up paying more tax on the conversion if that happens.
Distribution Rules for a Roth IRA
First, it is important to note that any contribution to a Roth IRA can be taken as withdrawal at any time tax and penalty free.
Qualified Roth IRA Distributions
As you may have picked up on, there are two boxes to check to make a Roth IRA distribution qualified (tax and penalty free distributions of the earnings).
Age 59.5
Like any qualified or IRA account, you have to be 59.5 years old to avoid the early distribution penalty of 10%. With the Roth IRA account, you would also pay tax on earnings prior to age 59.5. Exceptions to the 59.5 year age rule are death, disability, or a first-time home purchase ($10,000 lifetime limit).
The 5 Year Clock
To take distribution of the earnings in your Roth IRA account you have to have had a Roth IRA account open for five years. The clock starts on Jan. 1 of the year toward which you made your first contribution. Being that contributions for a given year can be made up until the tax deadline (usually April 15th of the following year) any contribution made for a given year (we’ll use 2023 as an example) between Jan 1, 2023 and April 15, 2024 would start that clock on January 1, 2023.
Even if a person has more than one Roth account, all Roth accounts are considered one. Also, regarding the five-year clock, it doesn’t matter what account was opened first, there is just one clock for all Roth account contributions. So even if you have a Roth account that you contributed to a year ago, but you have another Roth account you contributed to five years ago, the contribution clock is satisfied. As a matter of fact, if you had opened and contributed to a Roth account but closed it after 2 years, then later opened and contributed to another and it had been opened three years, your Roth contribution clock is satisfied.
Another Clock
Contributions and earnings are not the only way funds can end up in a Roth IRA account. As we’ve discussed, a person can also do Roth Conversions from a pre-tax account like an IRA or many qualified account 401k (if plan rules support this). Each time you do one of these conversions they have their own five-year clock that begins on January 1 of the tax year of the conversion. Prior to age 59.5, each conversion (the amount of pre-tax funds you paid tax on and moved into a Roth IRA) has to meet the five-year clock in order to be penalty free. After age 59.5 this conversion clock does not matter.
Ordering Rules for Roth IRA Distributions
When you take distributions from your Roth IRA, from a tax and penalty perspective, this is the order the IRS considers funds withdrawn:
- Contributions: remember contributions can be taken anytime tax and penalty free. These amounts are also called the basis in your account.
- Conversions: the conversion amount is the amount you took from a pre-taxaccount and on which you paid taxes (the amount was added to your gross income). Conversions are distributed next on a FIFO (first in, first out basis). If the conversion was made up of both pre-tax and after-tax funds, the pre-tax amounts would be distributed first. The withdrawal of conversion amount is tax free (you’ve already paid tax on those amounts),but would be subject to the 10% penalty if the five year conversion clock for that particular conversion has not been met. After age 59.5 the conversion clock is not needed because at that age or later the 10% penalty does not exist.
- Earnings: earnings (or the amount of income or growth made on theinvestments in the Roth IRA account) are distributed last. Earnings are only tax free if the account owner is 59.5 or older and has the five-year contribution clock is satisfied. Before age 59.5 they would also pay the 10% early distribution penalty on these amounts.
Why a Roth?
Roth accounts with all their rules can be confusing but are a great tool for implementing strategies for maximizing tax savings opportunities in retirement. Tax free income allows for more control over how much taxable income you have in any given year. This can affect how much tax you pay on your Social Security benefits, how much premium tax credit you qualify for, etc. If you believe your tax rate will be higher in retirement than in your accumulation years, contributing during your accumulation years is a no brainer. Roth conversions as you move into retirement may also make sense, but require careful planning from a tax standpoint. Watch for future posts for tax savings strategies.
[1] I.R.C. § 590(a). Roth IRAs. https://www.irs.gov/publications/p590a#en_US_2023_publink1000231022
[2] I.R.C. § 590(a). https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2024
[3] [3] I.R.C. § 590(a). Roth IRA
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