A critical component of a financial plan is your retirement strategy. Today, you will learn everything you need to know about a ROTH IRA.
A ROTH IRA is primarily an individual retirement account; the contributions are not tax-deductible. You may contribute after-tax dollars to the account if you have qualified earned income. ‘After tax dollars’ means you’ve already paid taxes on the money.
Your eligibility to contribute to a ROTH IRA is based on earned income. If your Modified Adjusted Gross Income (MAGI) is within or below the federal income limits shown below, you may contribute.
For 2023 the income limits are as follows:
Single or head of household
- $138,000 – $153,000
- $218,000 – $228,000
The contribution limit per year is $6500. For individuals over age 50, an additional $1000 catch-up amount is allowed, totaling $7500 per year.
If you don’t have earned income, you are not eligible for a ROTH IRA and thus cannot contribute to a ROTH IRA. However, if your spouse has qualifying income, they can contribute to your ROTH IRA and their own. Their income must equal or exceed the total of ROTH IRA contributions.
Why Consider a ROTH IRA?
There are two reasons to consider a ROTH IRA. First, you believe you will be in a higher tax bracket in the future. Second, you believe taxes will be higher in the future.
Benefits of a ROTH IRA
Anyone with qualified earned income can contribute to a ROTH IRA. Investment gains inside the ROTH IRA are tax-free, and you never pay taxes on these gains later. Qualified withdrawals of principle are also tax-free after the age of 59½.
You can also apply the five-year rule (discussed below) and the account can be maintained indefinitely.
There are no required minimum distributions (RMD) for a ROTH IRA. With changes passed in 2023, ROTH 401k’s now have no RMDs. There are also no taxes to your heirs if they inherit one. The only negative is that you cannot take a tax deduction for contributions to a ROTH IRA.
Investing in a ROTH IRA
There is a lot of flexibility regarding what can be invested in. Think of the ROTH IRA as an envelope. What you put in the envelope is up to you.
You can invest in mutual funds, stocks, bonds, CDs, ETFs, gold, silver. You can even invest in cryptocurrency, real estate, or a franchise business. However, you cannot put life insurance or derivative trades inside a ROTH IRA.
Withdrawals can be tricky and might get you into trouble, so here are some basic rules. You can withdraw any amount up to your basis (your contributions) at any time, tax-free and penalty-free.
If you withdraw any gains above your basis before age 59½, you will pay taxes on the gains. An additional 10% penalty will also be assessed, as this is considered an early distribution. You will have the ability to get tax free withdrawals of investment gains in retirement.
If you want a guide to help you plan your retirement, click here to download The Retirement Plan Checklist.
There is also a five-year rule. If the account has been open five years and you are over 59½ there is no tax or penalty for withdrawals. For accounts open less than five years, you can only take out your basis.
If you have not had the account for five years, there are some exceptions to the rules. You can withdraw $10,000 per lifetime, for the purchase of a first home. This applies to you, your children, your grandchildren, or your parents.
Additionally, if funds are used for higher education, unreimbursed medical expenses, or adoption, there is no tax or penalty. With adoption, there is a $5000 limit.
A disabled ROTH IRA owner may withdraw funds at any time tax and penalty-free. Distributions from an inherited ROTH IRA are tax and penalty-free.
The Secure Act amended inherited IRA rules. The new owner must begin taking required minimum distributions based on their own age. 100% of any inherited IRA, whether ROTH or Traditional, must also be distributed by the 10th year of ownership.
If your income is above the qualifying income limit, you do have an option. This option is commonly referred to as a backdoor ROTH IRA.
Contributions are made to a Traditional IRA with no tax deduction taken for the contribution. You are essentially using after-tax dollars to fund the Traditional IRA. It’s important that you document these nondeductible contributions on IRS Form 8606.
After the funds are deposited into the Traditional IRA they are then converted to a ROTH IRA. This is also called a ROTH IRA conversion.
Using a ROTH IRA conversion does create a taxable event. You can convert as much of the Traditional IRA as you want at any time. However, you must consider the tax consequences. If you are ready to master your money and mindset, click here to download our free guide:
Converting $10,000 of a Traditional IRA into a ROTH IRA causes that $10,000 to be considered taxable income. Be careful not to put yourself in a higher tax bracket!
Many people overlook one key factor when it comes to conversions. Each tax year conversion has its own 5 year rule. This means your conversion in 2022 will have a 5-year time frame until 2027. The 2023 conversions will have a 2028 time frame.
Consult with a tax professional to see if this is a good move for you. If you believe taxes will go up in the future, ROTH conversions should become part of your retirement plan.
In this example a married couple has two children, a mortgage, and a joint income of $170,000 a year. For 2023 they would fall into the 22% tax bracket. However, after all deductions, they may have an adjusted gross income of $130,000. Before deductions their taxes would be $29,114.
After deductions their taxes are $19,214. By dividing line 24 by line 15 on IRS Form 1040 you can determine that their net effective tax rate is 11%.
Now let’s look into the future. When they retire, the mortgage is gone, and the children are on their own. Taxable income, consisting of pensions, Social Security, and investments, is now $100,000 a year.
With only being able to use the standard deduction, they are still in the 22% tax bracket. Taxes on their hundred thousand dollars of income would be $12,614. Their net effective tax rate would be 12.6%. This is an increase of 1.6% from 11% to 12.6%.
This couple would end up paying more in taxes at retirement just by using the current tax tables. What if taxes go up in the future? In 2025 the current tax table will revert to a higher tax table. The 22% tax bracket will become 25% and the highest tax bracket will return to 39.6%.
Does saving through a ROTH IRA help this couple’s tax situation in any way? Yes! If $10,000 of the $100,000 income came from a Roth it would reduce their taxes to $10,115. That is a savings of $2,499 every year, presuming their income remained the same.
ROTH IRA and Social Security
Every person’s Social Security is subject to being taxed at a 50% or 85% level. Generally speaking, approximately 50% of those receiving Social Security end up paying taxes on Social Security. This is determined by a person or couple’s provisional income.
Provisional income is adjusted gross income, investment income, interest earned, tax-free income, and 50% of your Social Security. Distributions from a ROTH IRA are not considered provisional income. ROTH distributions may assist in reducing the amount your Social Security is taxed.
Summary: What is a Roth IRA
The ROTH IRA is a great vehicle for reducing your taxes today and tomorrow. Working with someone that understands the IRS rules and regulations can significantly benefit your plans. Everyone wants to reduce their tax liability.
Waiting until you are close to retirement makes this a challenge. This type of planning should be part of you overall retirement plan. Starting early and having the willingness to reduce your tax deductions today can be extremely beneficial tomorrow.
Would you prefer to pay less taxes today or for the rest of your life? With the national debt currently at over 32 trillion dollars, it is difficult to conceive that taxes will remain stable. As I see it, the only way to pay this debt is to raise taxes in some manner.
To keep this from impacting you, meet with a Certified Financial Planner® and examine your tax situation. The clock is ticking.
If you do not have a retirement plan or you want to confirm you haven’t missed an important element, download The Retirement Plan Checklist here: