Updated on February 15, 2024
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Tax-free retirement money (or an unburdened gift for an heir)? The ability to take out contributions whenever you want? No RMDs? Yes, please: All of these are among the reasons that Roth IRAs, with their unique tax benefits, are so attractive to savers.
Unlike traditional IRAs, which get the contributor a tax break in the short term but will be taxed later on when withdrawals are taken, Roth IRA contributions are made after-tax—which means the distributions can be taken without income taxes, so long as certain rules are followed.
However, understanding those rules is critical. That’s because in some circumstances, you may end up paying taxes on Roth IRA contributions twice (!) if you don’t follow the IRS’s guidelines.
Below, we’ll dive into all things Roth IRA so you’ll know exactly what to expect when it comes to Uncle Sam’s cut of your retirement savings. After all, the last word anyone wants to pair with “taxes” is “surprise.”
The primary thing that sets Roth IRAs aside from traditional IRAs is the simple fact that they’re funded with after-tax dollars. That is, unlike a traditional IRA, Roth IRA contributions are not tax-deductible – but in exchange, you won’t have to pay taxes on Roth IRA withdrawals, so long as you follow the rules.
However, because they’re such a powerful savings vehicle, Roth IRAs are governed by certain guidelines including the five-year rule and contribution eligibility determined by the saver’s earned income (i.e., those who make over a certain amount won’t be eligible to contribute directly to a Roth IRA, though they may consider a backdoor Roth).
Here’s how it works.
As discussed, those who are eligible to contribute to a Roth IRA can make after-tax contributions—which is to say, contribute money they’ve already paid income tax on to their Roth IRA. Unlike a traditional IRA, this will not decrease the saver’s taxable income for that tax year, but tax-free withdrawals and qualified distributions can be taken under the right circumstances. That can make it a lot easier to know exactly what to expect as far as retirement income—after all, no one can predict the future of the tax code.
We’ll take a look at some of those circumstances below, but before we get there, let’s talk about the income limits the IRS sets out for Roth IRAs.
These income limits depend on the saver’s marital status as well as their income level—expressed as Modified Adjusted Gross Income (MAGI), which can be calculated using your tax return and may include income from investments as well as earned income.
While the IRS is given to changing these limits from time to time, for 2024, single filers who earn less than $138,000 can contribute up to the limit toward their Roth IRA, while married couples filing jointly must earn less than $153,000 to do so. Single filers who earn less than $228,000 may be able to contribute at a reduced amount, as can married couples who earn less than $218,000.
Once you’ve discovered you’re eligible to contribute to make Roth IRA contributions, how do you ensure you won’t pay taxes (again) when you withdraw the funds later?
One of the most important caveats to the Roth IRA is the five-year rule, which basically states that at least five years must have transpired since the account was opened before tax-free distributions can be taken. (And you can always take out your contributions since they were made with after-tax money.)
And, of course, to avoid the 10% IRA early withdrawal penalty, retirement savers should wait until they reach age 59½ to make their withdrawals unless they or their beneficiary otherwise meet the requirements to make a qualified distribution. (These include: the original account holder becoming disabled, the original account holder’s death, or the purchase of a first home, for which a lifetime limit of up to $10,000 can be withdrawn.)
Keep in mind that this early withdrawal penalty can come to bite you if you make an indirect IRA rollover and don’t re-deposit the funds in a timely way—and also that converting a traditional IRA to a Roth IRA can come with a tax burden, too.
Fortunately, though, so long as you follow these rules, you can trust that your Roth IRA will provide you with tax-free retirement income or an easy way to pass on earnings to your heirs.
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As tantalizing as the Roth IRA can be for savers, traditional IRAs still have their place. For instance, if you out-earn the Roth IRA income limits, a traditional IRA may be the best way available to you to save for retirement (and also get a tax break in the year you make the contributions). And for most earners, any individual retirement account is better than no individual retirement account.
Additionally, taxpayers who expect to be in a lower tax bracket at retirement might find a traditional IRA to be the more beneficial route, since they stand to see more overall tax savings than they might by paying at a higher tax bracket today before contributing the funds to a Roth. (However, this equation is always complicated by the fact that the tax code is given to change.)
If there’s one keyword that defines Roth IRAs, it’s flexibility. Even more so than the tax-free retirement income, many savers enjoy that Roth IRAs don’t have required minimum distributions (RMDs) during the original account holder’s lifetime, and if left as a gift, beneficiaries inherit the account tax-free.
Plus, contributions (though not earnings) can always be taken out of a Roth IRA account since the taxes have already been paid on them. For some savers, contributing to this type of IRA can feel like a comfort, since the funds are never truly locked away.
And, of course, for those who will end up paying a higher tax rate at the time of their retirement, Roth IRAs offer the opportunity to save money on the tax burden of the account overall. (Again, though, it can be as hard to predict the future of our financial circumstances as it is to predict the future of the tax code.)
Although traditional IRAs lack some of the flexibility of Roth IRAs, they are still an important tool for many savers. For instance, those who earn too much gross income to contribute to a Roth still have ready access to this retirement savings vehicle—and the tax deduction these tax-deferred contributions offer in the year they’re made. Of course, as discussed, traditional IRA distributions are taxed as ordinary income at the time they are withdrawn—which may be less favorable to those who end up in a higher tax bracket at retirement.
Because these two types of IRAs each have their own benefits, many savers hold one of each. In other words, the question doesn’t have to be, “Which is right for me? A traditional or Roth IRA?” Rather, the two account types can be held together to create tax-incentivized savings partnerships.
Keep in mind that, as with all things in life, there are always exceptions to the rule. For example, if you take Roth IRA withdrawals (including earnings) before the account has been open for five years or before you reach retirement age (59½), you may end up paying for it via the early withdrawal penalty or by paying income tax on the funds—again. Keep in mind that Roth IRAs, like traditional IRAs, are subject to annual contribution limits, and savers can be penalized for over-contributing. (For 2024, the limit is $7,000 across all IRA accounts, or $8,000 for those aged 55 or over.)
The good news is, the benefits often outweigh the limitations. Tax-free withdrawals and exceptions to the early withdrawal penalty for first-time home purchases make Roth IRAs a wonderful savings vehicle for those who are eligible to contribute.
While Roth IRAs are excellent retirement savings options for the original account holder, they are also a wonderful way to pass down tax-free gifts to heirs and beneficiaries. Keep in mind, though, that RMDs do kick in for Roth IRAs once they’ve been inherited.
For the retirer themselves, Roth IRAs can also be used to fund an annuity, which is another way to secure a tax-free income stream in your golden years.
Once again, it’s important to follow the IRS’s guidelines in order to ensure you can access your funds penalty-free and keep all the tax benefits that make the Roth so attractive in the first place.
If you attempt to make a Roth IRA withdrawal including earnings before you reach retirement age (or qualify for another of the qualified distribution circumstances highlighted above, such as certain real estate purchases), you’ll pay a 10% early withdrawal penalty on the funds. Additionally, if you fail to follow the five-year rule, your withdrawals won’t be tax-free, which is basically the whole point of a Roth account.
Whether you qualify to contribute direction to a Roth IRA or not, you may be able to convert a traditional IRA to a Roth IRA—or roll over another type of Roth account, like a 401(k), into your Roth IRA.
401(k) conversions specifically will have short-term tax consequences; the income tax you deferred paying on those traditional funds will need to be paid in order to land them in a Roth account. Still, the move can be worthwhile for the potential tax-free retirement income later down the line.
Savers who already have a traditional IRA and predict that they may be in a higher tax bracket in retirement would do well to consider a Roth IRA conversion today. That way, they’ll pay the taxes now, while their bracket is lower, which lowers the overall tax liability while also allowing the funds to grow tax-free. Keep in mind, though, that the short-term tax bill might be quite high, depending on how much money is already in your traditional account. Consult with a tax expert so you don’t end up with any unpleasant surprises.
You may also decide to rollover other types of retirement savings accounts, like 401(k)s, into an IRA. The tax structure will need to match (or, if you’re moving traditional funds to a Roth account, income tax will need to be paid in the interim).
Keep in mind that, like all investments, neither Roth nor traditional IRAs are FDIC-insured. With capital gains come risks, though these can be mitigated to some extent by diversifying your investments (which you can do in one step by purchasing ETFs or mutual funds). Get in touch with your brokerage for more details.
So long as you play by the rules the IRS sets, Roth IRAs carry a wide range of tax benefits and flexible policies that bring ease to your retirement plan. Of course, which account—or accounts—will work best for you depends on your specific financial situation, future tax expectations, and individual retirement goals.
A professional financial advisor can help you navigate the wide world of retirement planning—and so can Capitalize. If you’re considering rolling over your old 401(k) into an IRA, we’re here to help every step of the way – for free. We can even help you find (and recover!) old retirement funds you forgot about.
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