3 Facts You Should Know About Roth IRAs

Updated by John Posey on August 20, 2024

Below I have highlighted 3 facts that I believe are common misconceptions on how Roth IRAs can be used and how they work.

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 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.
There is no age limit for contributing to a Roth IRA provided you (or your spouse – The Spousal IRA Opportunity) have taxable income. With the passage of the SECURE Act in year 2020, traditional IRA contributions are allowed beyond age 70 ½ if you have earned income. You can contribute the lesser of your earned income or up to the IRA annual limit of $7,000 or $8,000 if over age 50 in 2024. Roth IRA contributions are allowed to the extent you are not phased out based on your income (In 2024, starting over $230k Modified AGI for Married Filing Jointly, starting over $146k 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. Roth IRAs are also not subject to required minimum distribution rules.
If you are a high earner subject to income phaseout limits, you can still make an IRA contribution that can ultimately become a Roth IRA. It may sound shady but it is 100% allowable and has been cleverly referred to as the Backdoor Roth IRA. It's a good option for those who do not have existing pre-tax IRAs. Check out this flowchart to see if you qualify - Can I Make A Backdoor Roth IRA Contribution? The Backdoor IRA method involves contributing to a traditional IRA (non-deductible contribution) and then subsequently converting it to a Roth IRA. It is often suggested to process 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 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 existing IRAs (including SEP IRAs and Simple IRAs), you or your accountant will have to complete IRS Form 8606 at tax time to determine the taxable portion of your Roth conversion (AKA – The pro-rata rule, further detail here) - this situation often limits the practicality of the Backdoor Roth IRA. It’s much simpler to execute this strategy for those who do not have existing before-tax IRAs including SEP & Simple IRAs given the pro-rata rule requirements. Employer-sponsored plans like 401(k)s are not a factor so you may want to explore pre-tax IRA account relocation/transfer options before executing. 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 where tax rates are relatively 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? I hope you found a few nuggets of useful info that will lead to more smart decisions with your money.

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