Allworth Co-CEO Scott Hanson breaks down the basics of Roth IRAs and Roth conversions.
You hear a great deal about Roth IRAs and Roth conversions, but what are they and how do they work?
The Roth IRA (established in 1998) is a relative newcomer to the investment world. It was named after legislation introduced by Senator William Roth, a WWII veteran, attorney, and long-time Delaware politician (though he was born in Montana), who wanted to make it easier for Americans to save for retirement.
While eligible individuals can fund a Roth IRA directly, a Roth conversion occurs when you move money from a pre-tax retirement account into a Roth IRA. This happens by:
- Converting money from a traditional IRA (to a Roth IRA)
- Rolling money over from a 401(k), 457, or 403(b)
- Moving money from a Simplified Employee Pension (SEP) IRA
- Or when you utilize a savings strategy known as a “backdoor Roth IRA”
What are the mechanics of opening a Roth?
First and foremost, if you’re considering either funding a Roth or undertaking a Roth conversion, speak to your advisor and your accountant. Your financial team understands the pertinent rules and laws, can weigh the current and future tax implications, and will be able to calculate whether it’s the right course of action for you.
All other considerations aside, the basics of moving money from a retirement account into a Roth IRA are simple, provided you follow the rules set up by the IRS and by your retirement plan administrator.
To transfer money from a retirement account to a Roth IRA, you need to:
- Identify a viable financial institution and open a Roth IRA
- Work with your retirement plan administrators and the institution that hosts the Roth to complete the paperwork
- Wait for the transfer to be initiated (could take a couple of weeks)
- Be prepared to pay the taxes due on the money you’ve moved
What are the contribution and income limits for a Roth IRA?
Whether directly funding or undertaking a conversion, one of the most important rules for investing in a Roth IRA is to understand that the money must be derived from income. Earned income is any taxable money you receive from a job, including tips and commissions, or money from a business that you own. In other words, if you have no income, you can’t simply take money you’ve inherited and open and fund a Roth IRA. You also can’t open a Roth with other types of passive income, such as money derived from:
- Alimony
- Child support
- Social Security
The contribution limits for a Roth are $6,000 this year (2022) and $6,500 next year (2023). If you are age 50, or older, the limits get a bump, to $7,000 this year (2022) and $7,500 next (2023).
But not only are there Roth contribution limits, the IRS sets strict, graduated income limits, as well.
You can contribute the full amount (listed above) to a Roth IRA if:
- You are single and make less than $129,000 ($138,000 in 2023)
- You are married (filing taxes jointly) and make less than $204,000 ($214,000 in 2023)
When your modified adjusted gross income (MAGI) surpasses the above levels, the maximum you can invest in a Roth IRA gradually decreases until you reach an income ceiling, after which, you are no longer allowed to contribute.
The maximum income levels for directly contributing any money to a Roth IRA are:
- $144,000 ($153,000 in 2023) for single filers
- $218,000 ($228,000 in 2023) for married couples filing jointly
(I should also note that Roth 401(k)s do not have income limits, making them a great savings tool for high earners who cannot contribute to a Roth IRA.)
What are the advantages of a Roth IRA?
Just because Roth IRAs have income and deposit limits doesn’t mean they aren’t flexible. On the contrary, there are numerous advantages to owning one. For instance, there are no age limits for making Roth IRA contributions, meaning, so long as you have at least as much earned income as you wish to contribute, up to the maximum, and if all other conditions are met, you can fund one at any age.
Retirement accounts such as traditional IRAs and 401(k)s are undeniably great savings vehicles, but at a certain point, the balance may become so high that a Roth conversion starts to make sense.
Here’s why.
Let’s say that you’ve been saving in a 401(k) (or a traditional IRA) for years. The money not only went into the account(s) before you paid taxes on it, but over time, interest has also accrued.
And all this has occurred without the government taking a penny.
This could mean that you are potentially headed for some massive future required minimum distributions (RMDs) that unnecessarily raise your tax bracket and eat up your hard-earned savings.
Now, to be clear, converting money to a Roth IRA is a taxable event. That is, since you almost certainly haven’t paid any taxes on the money in your retirement accounts, the amount transferred will be treated as ordinary income.
So, why not just continue what you’ve been doing and leave the money where it is?
Here are a few of the scenarios when converting money to a Roth IRA might make sense:
- You know that you’ll be in a higher tax bracket once you retire
- You have other losses or deductions that will offset the taxes that will be due upon conversion
- You plan on moving to a higher income tax state
But so long as you've owned it for at least five years, the best part of a Roth IRA is that it offers these other financial and tax-related incentives:
- Tax and penalty-free withdrawals after age 59 ½
- Tax-free growth
- No required minimum distributions (RMDs)
- Your Roth IRA beneficiaries won’t have to pay taxes on the windfall (but they will have to take RMDs)
What is a backdoor Roth IRA?
The phrase “backdoor Roth IRA” is misleading. The fact is, it’s not really a type of Roth, but rather, it’s a perfectly legal strategy for folks with higher incomes who aren’t otherwise eligible to directly contribute to one.
Let’s say you make $300,000 a year, which is over the IRS’s income threshold to open a Roth IRA. You could fund (there are restrictions) a traditional IRA, and then immediately roll the money into a Roth IRA. Even better, so long as all other legal criteria are met, you could conceivably complete a backdoor Roth IRA conversion every year.
I’ve often said this, but it bears repeating: One of the most important contributions I make as an advisor is to help keep my clients from making financial mistakes from which they can’t recover. With interest rates sky high, and with market volatility still a major concern, if you are considering making any changes to your investments, or if your overall financial situation has recently changed, or even if you just want to review your plan, you should immediately schedule an appointment with your advisor.
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