3 Facts You Should Know About Roth IRAs

Posted by John Posey on November 12, 2019

I had the opportunity to attend an IRA education workshop this past summer hosted by Ed Slott and was reminded of some special features that apply only to Roth IRAs. You might recognize Ed from the televised IRA workshops he has done for several years on PBS. Below I have highlighted 3 facts that I believe are common misconceptions on how Roth IRAs can be used and how they work.  

1. Distributions of Roth IRA contributions are not subject to tax or penalty regardless of your age. Many may be familiar with early withdrawal penalty of 10% for IRA distributions that occur prior to age 59 ½, but Roth IRAs don’t share this rule. You can always withdraw funds from your Roth IRA without tax and penalty up to your contribution amount (AKA – cost basis) which makes the prospect of taking a withdrawal much more practical. This feature alone makes it a unique savings vehicle offering the ability to access funds without the handcuffs of traditional tax and penalties applicable to most IRAs while also providing tax-free growth and earnings. Contribution amounts always will come out first when a distribution is made, then conversion amounts and earnings if applicable. To the extent you are withdrawing earnings or amounts that originated from converted IRAs, there can be tax and penalty. Conversion amounts will never be taxed (because they were taxed when you made the conversion) but to avoid the 10% penalty they must be distributed after five years from the date of conversion OR after age 59 ½ . Earnings amounts must be distributed after the five year hold period AND after age 59 ½  to avoid tax and penalty.
2. If you are over 70 ½ years old and still have earned income, you can contribute to a Roth IRA (assuming you haven’t hit the income phaseout limits – 2019 info click here). In the year you reach age 70 ½ , traditional IRA contributions are no longer allowed. This isn’t true for the Roth IRA as you can continue to contribute up to your earned income or the applicable annual limit ($6,000 or $7,000 if over age 50 in 2019) to the extent you are not phased out based on your income (In 2019, starting over $193k Modified AGI for Married Filing Jointly, starting over $122k Modified AGI Single filer). If you’re working beyond 70 and still want to save on a tax-preferential basis, a Roth IRA is  a great option. I should mention if you’re self-employed you can make Simple IRA or SEP IRA contributions beyond age 70 ½ which could provide some higher funding limits, but you’ll also need to start taking required minimum distributions as well. Roth IRAs are not subject to required minimum distribution rules.
3. If you are a high earner subject to income phaseout limits and you’re under 70 ½, you can still make an IRA contribution that can ultimately become a Roth IRA. It may sound shady but it is 100% allowable currently and has been cleverly referred to as the Back-Door Roth IRA. Unfortunately, it only works for people who are younger than 70 ½ and have earnings. The Back-Door IRA method involves contributing to a traditional IRA (non-deductible contribution) and then subsequently converting it to a Roth IRA. Ed Slott suggests processing the subsequent Roth conversion request after you receive your IRA statement documenting the IRA contribution or one month after the contribution rather than processing it simultaneously.  By having time pass between the between the contribution and the subsequent conversion, the theory is this will help avoid any possible contention with the IRS and the Tax Court (more info here). A special note – if you have after-tax (non-deductible contributions) funds in your IRA, you or your accountant will have to calculate the percentage of after-tax IRA funds among all your IRAs to determine the taxable portion of your Roth conversion (AKA – The pro-rata rule, further detail here). Another fun fact to be aware of is the back-door conversion is considered converted funds, NOT Roth IRA contributions. This would be important to people under 59 ½ as they must wait 5 years for penalty-free access to the money.

One final thought on Roth IRAs. You should ask your accountant  if you would benefit from doing partial Roth conversions each year if you have traditional IRAs or pre-tax retirement funds. Some refer to this as a tax bracket management strategy. The goal of this approach is to realize some income now and effectively use up your marginal tax bracket while not breaking through to a higher one. This can be a great strategy with those that have incomes that tend to fluctuate quite a bit from year to year as well as those in retirement that may be able to realize more income in lower marginal tax brackets while tax rates are historically low.  I’d suggest seeking out someone who has some knowledge in this area coupled with a willingness and desire to help evaluate it with you each year. Roth IRA conversions must be processed within the calendar year you intend them to be taxable so it’s important to plan on completing them well before the end of the year.

Did you feel your Roth IRA IQ jump up a few points? Mine sure did after to listening to Ed Slott for a couple days. I hope you found a few nuggets of useful info that will lead to more smart decisions with your money. 

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