How Does a Roth IRA Work?
James I. Moore, CFP®
A Roth IRA is a special type of individual retirement account (IRA) that allows tax-free growth. Whereas contributions to a traditional IRA are usually tax-deductible, contributions to a Roth IRA are not.
Contributions to a Roth IRA must be made with after-tax money, which means that there is no initial tax benefit like there is with a deductible contribution to a traditional IRA. But while distributions from a traditional IRA will count as taxable ordinary income, distributions from a Roth IRA will be completely tax-free as long as certain conditions are met.
Essentially, a traditional IRA provides an upfront tax deduction and tax-deferred growth. A Roth IRA provides no upfront tax deduction, but completely tax-free growth.
Roth IRA Rules to Keep in Mind
For 2025, the annual contribution limit is $7,000 per person. For those age 50-plus, the limit is $8,000. For 2026, the contribution limit is $7,500, or $8,600 if you’re 50 or older.
If your income is too high, you are not eligible to contribute to a Roth IRA. The relevant income number is your modified adjusted gross income (MAGI), which is your adjusted gross income (AGI) with certain amounts added back in.
For 2025, contribution limits begin to phase out at $150,000 MAGI for single filers and $236,000 MAGI for those married filing jointly. In 2026, they begin to phase out at $153,000 (single filers) and $242,000 (married filing jointly). However, even if your income is over the limit, you may still be able to put money into a Roth IRA by using a strategy we will discuss further on.
To contribute to a Roth IRA, you must have earned income equal to the amount you want to contribute. For example, if you want to contribute $7,000 to a Roth IRA for 2025, you must have at least $7,000 of earned income during 2025.
Earned income is compensation received from a job or personal services provided (wages, income from operating a business, etc.). Other income sources, such as Social Security, pensions, or investment dividends, do not count as earned income for the purposes of qualifying to make a Roth contribution.
Generally, since most retirees no longer have any earned income, they are not allowed to make Roth IRA contributions. This same rule applies when considering Roth IRAs for minor children. Many parents would love to contribute to a Roth IRA for a child, but this is not allowed unless the child has legitimate earned income for the year the contribution is made.
There is an exception to the earned income rule for married couples. A spouse with no earned income can make a Roth IRA contribution if the other spouse has enough earned income to cover the contribution.
For a distribution from a Roth IRA to be tax-free, the Roth IRA must have been open for at least five years, and the account owner must have reached age 59½.
Roth IRAs do have some flexibility for withdrawals if the account owner is younger than 59½. Because contributions are made with after-tax dollars, the contributions (but not earnings) can be withdrawn 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 allow you to withdraw earnings from the account tax-free before age 59½.
Required minimum distributions (RMDs) are not required from a Roth IRA while the account owner is alive. This ability to extend tax deferral is another significant benefit of a Roth IRA. However, RMDs are required from inherited Roth IRAs.
Roth Conversions
A Roth conversion is when you make a distribution from a traditional IRA and put the proceeds into a Roth IRA. Like any distribution from a pre-tax traditional IRA, the distribution amount will count as ordinary taxable income to you.
If you take a distribution from a traditional IRA before age 59½, the distribution is usually subject to an early withdrawal penalty. However, this penalty does not apply for a Roth conversion.
Backdoor Roth Contributions
Roth conversions are allowed regardless of income level. This means that even if your income is too high to be eligible to make a Roth IRA contribution, you are still allowed to do a Roth conversion.
This idea forms the basis of the “backdoor Roth” strategy. This strategy involves a high-income individual making a non-deductible traditional IRA contribution (since income level affects only the deductibility of a traditional IRA contribution, not the ability to make a contribution) and then converting that into a Roth IRA at a later time.
There is an important tax consideration to keep in mind when planning a backdoor Roth contribution. Due to the “pro rata rule”, if an individual has made deductible IRA contributions as well as non-deductible IRA contributions, it is not possible to just convert the non-deductible portion.
Therefore, if this individual did a Roth conversion, there would be no way to avoid having a portion of that conversion count as taxable income. And due to the “aggregation rule,” if an individual owns multiple IRA accounts, the IRS treats them all as one single IRA for tax purposes. This means that creating separate IRAs for deductible and non-deductible contributions would not help.
For this reason, a backdoor Roth strategy usually works best if there is no other traditional IRA in place besides the non-deductible IRA. However, it is OK if you own a 401(k) because that will not be considered as part of the IRA aggregation rule.
Roth IRA Strategy
So, does a Roth IRA make sense for you? Should you prioritize contributions to a Roth IRA or a deductible retirement plan? Should you do Roth conversions?
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 wonderful investment vehicles. Paying no tax on your investment growth is obviously preferable to paying ordinary income taxes at withdrawal (traditional IRAs) or capital gains taxes (taxable accounts). However, it is important to consider the opportunity cost of contributing to a Roth IRA rather than a tax-deductible retirement account, such as a traditional IRA or 401(k).
If you are in a relatively high tax bracket now and expect to be in a lower tax bracket when you start taking withdrawals from your retirement accounts, you will probably benefit more from the upfront tax deduction provided by pre-tax retirement plans. On the other hand, if you are in a relatively low tax bracket now and expect to be in a higher tax bracket in the 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, required minimum distributions, 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. This could be the first few years of retirement before RMDs and Social Security begin, or any year with lower-than-usual income.
Planning Opportunities
If you have questions about how these various Roth IRA strategies apply to your own unique situation, we are happy to help. Please feel free to schedule a complimentary phone call or meeting with one of our fee-only financial advisors.