How a Roth IRA Works Before and After Retirement

James I. Moore, CFP®

Roth IRAs have been growing in popularity, and for good reason. Compared with traditional IRAs and most retirement plans like traditional 401(k)s, Roth IRAs [and Roth 401(k)s] are unique in that they allow not just tax-deferred growth, but completely tax-free growth. The possibility of being able to put money into a Roth IRA, letting it grow for 10, 20, or 30 years, and never having to pay any taxes on it ever again is a very compelling idea!

While utilizing a Roth IRA can be a valuable part of your overall financial plan, it does not make sense for everyone (more on this later). In fact, your strategy regarding Roth-style accounts will likely change over time, depending on your life stage and financial situation. To make the best decision for your financial plan, you should first understand how a Roth IRA works.

Taxation of a Roth IRA

Contributions to a Roth IRA are not deductible like they are with a traditional IRA or 401(k). However, once a contribution has been made to a Roth IRA, it is then allowed to grow tax-free if certain rules are met. Withdrawals are not taxable as long as the Roth IRA has been open for five years and the owner is older than 59 ½.

Roth IRAs do have some flexibility for withdrawals before the account owner has reached age 59 ½. Because you contributed with after-tax dollars, you can withdraw your contributions (but not earnings) at any time without tax or penalty. There are also specific exceptions (such as death, disability, or being a qualified first-time home buyer) that can make it possible to withdraw the earnings from the account tax-free before age 59 ½.

Making Contributions to a Roth IRA

Even if you would love to put as much as possible into a Roth IRA, rules limit who can contribute and how much they can contribute.

The contribution limit for 2019 is $6,000 per person. For those age 50 or older, the limit is $7,000.

Your adjusted gross income must be below a certain amount. For 2019, contribution limits begin to phase out at $122,000 for single filers and $193,000 for those married filing jointly.

There is no age restriction for making contributions, as there is with a traditional IRA. You may make contributions to a Roth IRA even if you are older than 70 ½.

However, you must have taxable compensation equal to the amount you want to contribute. For example, if you want to contribute $4,000 to a Roth IRA for 2019, you must have at least $4,000 of earned income for 2019.

Generally, since most retirees no longer have earned income, they are not allowed to make Roth IRA contributions. This same rule comes into play when considering Roth IRAs for minor children. Many people would love to contribute to a Roth IRA for a child, but this would not be allowed unless that child had legitimate earned income for the year the contribution was made.

There is an exception to this rule for married couples—a spouse with no earned income can make a Roth IRA contribution if the other spouse had enough earned income to cover the contribution.

If one of these limitations applies to you, does that mean that there is no possible way for you to get money into a Roth IRA? Luckily, there is another potential strategy available.

Roth Conversions

A Roth conversion allows you to turn an existing traditional IRA (or a portion of the balance) into a Roth IRA. Since you are taking money out of a traditional IRA, you will have to pay taxes (but no early withdrawal penalty) on the distribution amount.

Roth conversions are allowed regardless of income level. So even if your income is high enough to exclude you from being able to make a Roth IRA contribution, you would still be allowed to do a Roth conversion.

This idea forms the basis of the “backdoor Roth” strategy. Basically, this strategy involves a high-income individual making a non-deductible traditional IRA contribution (since income level affects only the deductibility of a contribution, not the ability to make a contribution) and then converting that into a Roth IRA.

One caution with using the “backdoor Roth” strategy—if an individual has multiple IRA accounts, the IRS treats them as one when determining how much of the withdrawal will be taxed. This means that if someone has a deductible IRA and a non-deductible IRA, it is not possible to just convert the non-deductible IRA.

If this individual did a Roth conversion, a portion of it would be considered taxable. For this reason, a “backdoor Roth” strategy usually works best if there is no other IRA in place besides the non-deductible IRA.

Required Minimum Distributions

Once you turn 70 ½, you must start taking required minimum distributions (RMDs) from your traditional IRA every year. However, RMDs are not required from a Roth IRA while the owner is alive. This ability to extend tax deferral is another significant benefit of a Roth IRA.

RMDs are required from inherited Roth IRAs, but unlike traditional inherited IRAs, the distributions will usually not be taxable to the beneficiary.

Roth IRA Strategy

So, does a Roth IRA make sense for you? What part should a Roth IRA play in your financial plan? As fee-only financial advisors in Fullerton, these are common questions that we address with our clients. The best strategy for you will depend on your unique financial situation, but here are a few general guidelines.

All else being equal, Roth IRAs are great! Paying no tax on your investment growth is obviously preferable to having to pay ordinary income taxes at withdrawal (in traditional IRAs) or capital gains taxes (in taxable accounts). However, it is important to consider the opportunity cost of contributing to a Roth IRA instead of a tax-deductible retirement account such as a traditional IRA or 401(k).

If you are in a relatively high tax bracket now and you expect to be in a lower tax bracket when you eventually start taking withdrawals from your retirement accounts, you will probably benefit more from the upfront tax deduction of a traditional IRA. On the other hand, if you are in a relatively low tax bracket now and you expect to be in a higher tax bracket in future, you will probably benefit more from contributing to a Roth IRA.

The general principle is that you want to defer taxes when your marginal rate is high and pay taxes when your marginal rate is low. It may sound simple enough, but estimating your future tax rate will likely take some in-depth planning. You will need to consider all sources of future income, such as Social Security, RMDs, and capital gains from investments. Other factors, such as estate planning concerns and the uncertainty of future tax law changes, should also be considered.

Sometimes there are windows of opportunity where doing a partial Roth conversion can be very beneficial. For example, for an individual who retires at age 65 with a significant amount saved in retirement accounts, there could potentially be about five years before required minimum distributions and Social Security benefits begin. During those five years of relatively lower income, it could be valuable to take advantage of the temporary lower tax brackets to convert some of those pre-tax IRA accounts into Roth accounts.

It may seem unintuitive at first to intentionally increase your taxable income and pay more taxes now, but by lowering the amount of your future RMDs and recognizing as much income as possible in the lowest tax brackets, you could actually pay less tax over time.

Many people can benefit from utilizing a Roth IRA, but it may not make sense for everyone. It is important to understand how a Roth IRA works and how it would affect your specific situation to determine how it could fit within your financial plan.

Schedule a 15-minute discovery call with a fee-only financial advisor to discuss your personal situation.

James I. Moore, CFP®