Roth IRAs are powerful and flexible financial planning tools, and they're also complex. Many people aren't familiar with all aspects of these accounts. Here are nine facts about Roth IRAs that may surprise you and have an impact on your retirement planning decisions.
Key Takeaways
- There are multiple advantages to funding a Roth IRA and specific strategies that can be beneficial for retirement planning.
- Contributions to a Roth IRA can be withdrawn at any time without penalties or tax consequences.
- High-income earners can overcome income limits by contributing to traditional IRAs and converting to a "backdoor" Roth IRA.
- Unlike traditional IRAs, Roth IRAs don't require distributions at a certain age.
- You can contribute to a Roth IRA on behalf of your spouse through a spousal contribution.
Roth Contributions Can Be Used As Emergency Funds
Roth contributions aren't tax deductible. The advantage to this is that you can withdraw your contributions at any time, for any reason, and no taxes or penalties will apply. With this kind of liquidity, a Roth IRA can double as your emergency fund.
But keep in mind that the definition of "contributions" in this context doesn't include amounts converted to a Roth, nor does it include investment gains. For example, taxes and penalties may apply if you put in $5,500 and it grew to $6,000 and you withdrew the $500 gain. You could withdraw the $5,500 of contributions without taxes or penalties, but not necessarily the earnings, depending on several factors.
Some Can Use a Non-Deductible IRA To Fund a Roth
You can't contribute to a Roth IRA if you earn too much money—or can you? Some people who have all their other retirement money inside qualified retirement accounts can make a non-deductible IRA contribution each year then convert that to a Roth,thusannually funding their Roth IRA. This is sometimes called a "backdoor Roth."
The key to making this work without paying extra taxes is making sure you don't have other IRA accounts.
Note
In some cases, you can even roll a self-directed IRA back into a company plan so you could use the backdoor Roth strategy in future years without having to pay taxes on the converted amount.
You Can Roll After-Tax 401(k) Contributions to a Roth IRA
Many employer plans allow you to make after-tax contributions. These after-tax contributions can be rolled directly into a Roth IRA at retirement. Any investment gain on the after-tax contributions can't go into the Roth, but the amounts you contributed can.
You can accumulate after-tax savings and later use it to fund a future Roth IRA if your employer's plan offers this feature. This is advantageous in retirement because Roth IRA withdrawals aren't taxable, and they don't impact other factors on your tax return the way traditional IRA withdrawals do.
Roth IRAs Have No Required Minimum Distributions (RMDs)
One great thing about Roth IRAs is that, unlike traditional IRAs, there's not an age where you must begin taking money out. This means there's no delayed tax bomb waiting for you.
Note
Your heirs will have to take required distributions from the Roth if they're not your spouse, but those distributions will be tax free to them.
You Can Contribute to a SIMPLE IRA and a Roth IRA
You can contribute to a Roth IRA as well as to a SIMPLE IRA as long as your adjusted gross income (AGI) is below the Roth IRA contribution limit, maximizing the amounts you're saving for retirement. The contributions to the SIMPLE IRA will be deductible, and the contributions to the Roth will not.
This dual-funding strategy gives you the ability to reduce your taxable income now and have some funds in the Roth accumulate for tax-free benefits later in retirement. This could be advantageous for someone who is self-employed and trying to save as much as possible for the future.
Your Employer Plan May Allow Roth Contributions
Many 401(k) plans offer the ability to make Roth contributions. This is called a "designated Roth account." Check with your employer to see if their plan provides you with the ability to choose which type of contribution you want to make.
It has to be all Roth or all tax deductible with some plans. Other plans allow you to do some of each. If your employer plan doesn't currently allow Roth contributions,request that they add it next time they amend their plan.
Age Is Not the Biggest Factor
Conventional wisdom says the younger you are, the more time you have for your money to grow tax free inside a Roth. It's true that more time makes Roth IRAs better, but age isn't the primary factor to consider when you're determining whether to fund a traditional IRA or a Roth IRA.The primary factor is your tax brackets, both your marginal tax rate now and your expected marginal rate in retirement.
If your expected tax rate in retirement is likely to be lower than your tax rate now, the deductible contributions may be better. Roth accounts may make a lot of sense for you if your tax rate is likely to be the same or higher inretirement, which is often the case for those who have large 401(k) or IRA accounts.
You May Be Able To Make a Spousal Roth Contribution
You can make an IRA contribution on your spouse's behalf even if they have no earned income, as long as you have earned income. This is called a spousal IRA contribution. Many couples can double their tax-favored retirement account savings by taking advantage of this.
Note
Ask your accountant or financial advisor if your income is such that you're eligible to make a spousal Roth contribution.
Roth Conversion Calculators Miss Some Things
You can convert traditional IRA or 401(k) money to a Roth. Many online retirement calculators project the results of such transactions to help you see if it might make sense for you. But there are many things that these online Roth conversion calculators can miss.
They don't factor in the impact of future required IRA withdrawals and how that impacts the taxation of your Social Security benefits. A Roth can help reduce the impact of this. When you factor everything in, Roth conversions can be more advantageous in many cases than online calculators may lead you to believe.
Frequently Asked Questions (FAQs)
Is there a limit on how many Roth IRAs I can have?
You can open as many IRAs and as many types as you like, but the amount you can contribute (in the aggregate) is still limited to the yearly cap imposed by the Internal Revenue Service (IRS).
Should I open a Roth or traditional IRA?
The type of IRA that's best for one person might not be the best for another because each has unique traits and benefits. Younger people generally have more time for funds to grow tax free in a Roth account. You can also consider your current income tax rate and your potential future tax rate during retirement to help you decide. By comparison, traditional IRA contributions are tax deductible, but withdrawals will be taxed later as income. You'll want to choose the account with optimal tax treatment for your situation.
What should I do if I contributed too much to my Roth IRA?
The IRS sets yearly limits on Roth IRA contributions, and a 6% tax penalty applies for breaching these. The limit was $6,000 for people under age 50 in 2022, with an additional $1,000 catchup contribution for anyone older. This increases to $6,500 and $7,500 respectively in 2023. You must withdraw the funds in excess of these limits by the due date of your income tax return to avoid paying the penalty.
