Roth IRAs allow investments to grow tax-exempt until retirement and offer tax-free withdrawals.
These tax-advantaged individual retirement accounts offer varied investment opportunities and exceptional tax benefits.
You contribute to a Roth IRA with money you already paid taxes on. The money compounds tax-free, and you can make tax-free withdrawals at age 59½.
Additionally, there are no required minimum distributions (RMDs), meaning you don’t need to make withdrawals by a certain point. You can withdraw investments without paying additional taxes or defer withdrawals until you are ready.
Roth IRA – One of the Best Retirement Tools
Everyone needs to plan for their retirement. Even if you serve in the military long enough to earn a pension, it might not be enough for your golden years.
Retirement accounts such as the Thrift Savings Plan, 401(k) plans and IRAs are great ways to take your retirement planning into your own hands.
Types of IRAs and Why a Roth IRA Rules
Most people have two types of IRAs available to them – traditional IRAs and Roth IRAs. While similar, there are differences in paying taxes on contributions and withdrawals.
Here is a Primer on Traditional and Roth IRAs
- Traditional IRA: Contributions are tax-free if you meet income requirements, and withdrawals are taxed in retirement years. There are required minimum distributions once you reach age 72.
- Roth IRA: Contributions are made from already-taxed income, and withdrawals in retirement are tax-free. There are no required minimum distributions.
Let’s break this down in simple terms.
With a traditional IRA, you can take a tax break on your income now, but you will have to pay taxes when you withdraw retirement funds. You must also withdraw from your account once you reach the required minimum distribution age, regardless of your income needs.
With a Roth IRA, you make contributions from income that was already taxed, making you eligible for tax-free withdrawals in retirement.
This is a great deal, especially if you are in a lower tax bracket than you anticipate being in retirement. It also takes the guesswork out of retirement planning, since you know the money in your account is not taxable.. Finally, you aren’t required to take distributions, so you can leave money in your account and continue to let it grow. (This can also be advantageous for estate planning.)
Roth IRA Eligibility Requirements
There are two main Roth IRA eligibility requirements:
- You must have earned income.
- You must meet income requirements.
The earned income must be taxable and can include wages and salaries, tips, bonuses and other compensation related to services you’ve provided. Income from interest, dividends or other investments does not qualify as earned income for Roth IRA purposes.
Note: Military members have a special provision. The Heroes Earned Retirement Opportunities (HERO) Act allows military members with tax-free combat pay to contribute to Roth IRAs and other retirement plans.
2023 Roth IRA Income Limits
There are caps on earnings and contributions to a Roth IRA.
For the 2023 tax year, Roth IRA eligibility begins phasing out at an annual modified adjusted gross income (MAGI) of $138,000 for single tax filers. Single tax filers are ineligible to make Roth IRA contributions when their income reaches $153,000. The limits are higher for married filing jointly, with eligibility phasing out starting at $218,000 and ending at $228,000.
The following table breaks down Roth IRA income limits.
| Filing Status | Modified AGI | Allowable Contribution |
|---|---|---|
| Married filing jointly or qualifying widow(er) | $218,000 or less | Up to the annual contribution limit |
| More than $218,000 but less than $228,000 | Partial amount | |
| $228,000 or more | No contribution | |
| Married filing separately and you lived with your spouse at any time during the year | Less than $10,000 | Reduced amount |
| $10,000 or more | No contribution | |
| Single, head of household or married filing separately and you did not live with your spouse at any time during the year | $138,000 or less | No contribution |
| More than $138,000 but less than $153,000 | Partial contribution | |
| $153,000 or more | No contribution |
What to Do if Your Income Exceeds Roth IRA Contribution Limits
The tax advantages for IRAs are generous, so the federal government limits them to people who fall within certain income brackets. Suppose you don’t meet income requirements to get the tax benefits from the traditional IRA or contribute directly to a Roth IRA. In that case, you can contribute to a nondeductible traditional IRA and convert it to a Roth IRA later. It’s like a back door that enables anyone to contribute to a Roth IRA, regardless of their MAGI.
Roth IRA Contribution Limit Rules
The next thing to consider is how much you can contribute to your Roth IRA.
If you meet income requirements, then you can contribute up to $6,500 for 2023 if you are younger than age 50.
If you’re age 50 or older you can contribute $7,500. (The additional $1,000 represents a catch-up contribution to help those closer to retirement better reach their investment goals.)
Contribution limits for both Roth and traditional IRAs are the same, and the limits apply to all your IRAs for the specified tax year. Make sure you don’t exceed your contribution limits across both accounts.
The following chart shows IRA contribution limits for 2002-2023.
Roth IRA Distribution Rules
Distributions are among the main benefits of using a Roth IRA instead of a traditional IRA. Distributions from Roth IRAs are tax-free, whereas traditional IRA distributions are taxable. In addition, there is no required minimum distribution age with a Roth IRA.
While you can withdraw contributions at any time, tax-free and penalty-free, that does not apply to earnings or interest on your contributions.
To avoid paying penalties on Roth IRA withdrawals for earnings or interest, you must wait at least five years from the date you contributed the funds and be at least 59½ years old.
This is called the five-year rule.
Exceptions for Early Roth IRA Withdrawals
There are exceptions to the Roth IRA withdrawal rules in certain situations. For example, you may be able to make penalty-free withdrawals if you become disabled, want to purchase your first home or pay for qualified educational expenses.
Read more about Roth IRA withdrawal rules and consult with a financial planner or tax professional before making any early Roth IRA withdrawals.
Early Roth IRA withdrawals not qualified under Internal Revenue Service (IRS) rules may be subject to a 10% early withdrawal penalty.
Roth IRA Conversions
Moving money from a traditional IRA into a Roth IRA is called a Roth IRA conversion.
Many people choose to do Roth IRA conversions because Roth IRAs have tax advantages over traditional IRAs. Roth IRA distributions are not considered taxable income. The lack of required minimum distributions also gives Roth investors more long-term flexibility.
Deductible and Nondeductible Traditional IRAs
There are two types of conversions: conversions from deductible traditional IRAs and conversions from nondeductible traditional IRAs.
Deductible IRAs are those where you deduct the contribution on your taxes.
Nondeductible IRAs are those without a corresponding tax deduction. People whose income exceeds the traditional IRA and Roth IRA income limits may use these.
Tax Implications of the Roth IRA Conversion Process
During the conversion process, you add the money from a traditional IRA that you rolled into a Roth IRA to your annual taxable income for that year. It’s taxable income because you did not pay taxes on contributions or earnings. The IRS still needs to assess taxes on that income and its gains. So, you pay when you convert and file your taxes the following year.
Nondeductible IRA conversions are not taxable income, as you did not receive a tax deduction for the original contribution. However, you will pay taxes on any nondeductible IRA gains when you convert to the Roth IRA.
To avoid taxable gains, convert a nondeductible IRA to a Roth IRA as soon as possible after opening it. This is called a backdoor Roth IRA.
The Pro-Rata Rule for Backdoor Roth IRAs
The IRS requires taxpayers who convert traditional IRAs to Roth IRAs to convert them on a pro-rata basis. That means that if you also have deductible IRAs, you can’t only convert your nondeductible IRAs to a Roth IRA. You must convert them proportionately, based on the total value of all your IRAs. This way, the IRS receives taxes at the time of conversion. IRS Form 8606 will walk you through the math.
This is an advanced matter worth investigating with a tax professional or fee-only financial planner.
Related:
- Roth IRA Conversion Timing (Part One)
- How to Optimize Roth Conversions: Why Timing Is Important (Part Two)
- Roth Conversion for Your TSP Account – Five Tax-Planning Considerations
Taking Advantage of Roth Conversions (Timing Is Everything)
When you pay taxes on the money you roll over, you pay taxes on the current value of the money. That means you can take advantage of economic downturns or your current tax bracket.
Future distributions from newly created Roth IRAs are the same as any other Roth IRA – they are nontaxable.
Investors currently in a low tax bracket often invest in Roth IRAs because they expect to be in a higher tax bracket when they retire. This is common for those who have recently retired or are between jobs.
Many people convert a traditional IRA into a Roth IRA when the economy struggles because their traditional IRA has less value, resulting in a lower taxable amount.
Who Is Eligible for Roth IRA Conversions?
Most people are eligible to convert a traditional IRA into a Roth IRA. However, you cannot convert a traditional IRA if you inherited it from someone other than a spouse.You can convert traditional IRAs to Roth IRAs even if you have made a rollover within the same year, according to the IRS.
Options for Converting Traditional IRAs into Roth IRAs
There are two ways to move money from a traditional IRA into a Roth IRA.
- You can convert the funds yourself by taking a distribution from the traditional IRA and rolling it into a Roth IRA within 60 days.
- You can instruct the bank or broker who manages your traditional IRA to transfer the money into a Roth IRA for you.
Most investment firms are happy to initiate and process the Roth conversion or rollover for you. This is typically the easiest and safest method since you avoid potential mistakes or penalties.
For example, if you cash out your IRA without rolling the IRA funds into your new IRA within 60 days, it is treated as a withdrawal instead of a conversion. Also, you would owe taxes on the total amount plus penalties if you are younger than 59½.
Whether you roll over or transfer funds, it’s necessary to use the entire traditional IRA distribution amount to fund the Roth IRA to avoid early withdrawal penalties and fees. You cannot keep any of the money as cash.
Comparing Roth IRAs to Other Retirement Plans
Roth IRAs offer different benefits than other retirement plans or taxable investments. The most important benefits of investing with a Roth IRA are:
- Tax-free withdrawals during retirement
- No required minimum distributions, so you can let your money compound for longer periods
- Ability to make tax-free and penalty-free withdrawals of your contributions at any time
Comparing Roth IRA to Traditional IRA
There are several similarities between traditional and Roth IRAs, including where you can open them and often the contribution limits. There are also income limits for tax-deductible traditional IRAs and Roth IRA contributions, so be sure to read up on the IRA contribution limits page for more information.
There are also differences between these two retirement accounts.
The fundamental differences between traditional and Roth IRAs boil down to how and when the money is taxed and how and when you can make withdrawals.
Traditional IRA contributions may be tax deductible, and the funds are taxed when you make a withdrawal. Roth IRA contributions have already been taxed, and withdrawals and qualified distributions are tax-free.
The next major difference is how and when you make withdrawals. Traditional and Roth IRAs list age 59½ as the minimum age requirement for penalty-free withdrawals. You can also make qualified distributions on your earnings penalty-free and tax free at this age as long as your Roth IRA has been open for at least five years.
However, traditional IRAs require account holders to make minimum required distributions once they reach age 72. Otherwise, they face stiff tax penalties.
Roth IRAs do not have required minimum distributions. You can read more about these two plans in the article: Comparing Roth IRA vs. Traditional IRA.
Comparing Roth IRA to Traditional 401(k) Plans
Some companies offer traditional 401(k) plans and Roth 401(k) plans. The Roth 401(k) has similar benefits to a Roth IRA but follows the contribution limits for 401(k) plans. Traditional 401(k) plans are closer to traditional IRAs, as they offer a current tax deduction, with taxable withdrawals in retirement age. All 401(k) plans also have a required minimum distribution age. Unlike a Roth IRA, the Roth 401(k) requires participants to take required minimum distributions once they reach the required age.
Where to Invest — 401(k) or IRA?
People often ask where to invest first – 401(k) or IRA. A traditional 401(k) plan is usually better if your employer offers a company match on your investment.
Take the free money, then contribute to the Roth IRA if you can afford to contribute beyond that.
Should You Contribute to a 401(k) Without an Employer Match?
If your employer does not offer a 401(k) match, you may be better off contributing to a Roth IRA. Here’s what you need to know.
How Many Retirement Accounts Can You Have?
You can have several retirement accounts, including a 401(k), 403(b), Thrift Savings Plan or IRA. You may also have a self-employed retirement plan.
However, the IRS lumps IRAs and retirement plan accounts together. So be careful to stay within annual contribution limits for IRAs and other retirement plans.
Who Should Open a Roth IRA?
A Roth IRA is a great investment option if you’re in a lower tax bracket now than you expect for the future.
You can pay taxes at a lower tax rate, then make tax-free withdrawals when you reach retirement age.
Why Young People Should Open a Roth IRA
Income potential in most career fields grows over time, so young people who start their careers in a low tax bracket have the most to gain from opening a Roth IRA.
Why Military Members Should Open a Roth IRA
Military members can make tax-free Roth contributions in a war zone, then make tax-free withdrawals in retirement.
This means your contributions, growth and withdrawals are all tax-free.
Some military members may qualify for additional time to contribute to their Roth IRA beyond the normal cutoff date if their military duties permit a tax extension.
Military Members Should Open Roth IRAs.
Getting Started With a Roth IRA
Opening a Roth IRA is easy and takes only 10-15 minutes. Simply go to the bank or brokerage company you wish to do business with, fill out some paperwork and initiate a money transfer.
If you want to read more on Roth IRAs first, check out these articles:
How to Invest Your Roth IRA Funds
How you invest your money is a personal decision. Consider your other current investments, desired asset allocation, investment timeline and risk tolerance.
That said, some investments are best suited for a Roth IRA in the context of your overall investment portfolio. Because of the Roth IRA’s unique tax rules, you won’t pay taxes on any growth in the funds in your Roth IRA. Look for funds that maximize your growth potential in your Roth IRA.
Conversely, consider investing in funds with lower growth potential in your traditional retirement accounts because you will pay taxes on those funds when you withdraw them at retirement age.
That generally means placing equities (stocks) in a Roth account and bonds and fixed income in a traditional account. This isn’t a hard-and-fast rule, and you may have to adjust as your portfolio grows. But, thinking about the long-term growth of the funds in your retirement accounts is very important.
Looking for more investing information? Here are some tips for first-time investors.
Maximize Your Roth IRA Contributions
The 2023 maximum contribution limit for a Roth IRA is $6,500 per year or $7,500 for those older than 50.
Most people can’t contribute $6,500 at once, which is OK. A great way to invest is to set up automatic investments in your Roth IRA account.
Determine how much you can afford each month and automatically contribute that amount. If you want to max out your Roth IRA contributions each year, you must contribute about $541 per month ($625 if you are older than 50).
Benefits of Automatic Contributions
Making automatic contributions guarantees you’ll stick to your monthly IRA savings goals.
You can also take advantage of dollar cost averaging, which ensures you will buy more investments when values are low, and fewer when values are high. Hopefully, your investment growth will average out in your favor in the long run.
Written By: Ryan Guina with themilitarywallet.com
