Table of Contents
- Roth IRA – One of the Best Retirement Tools
- Types of IRAs, and Why a Roth IRA Rules
- Roth IRA Eligibility Requirements
- 2022 Roth IRA Income Limits
- Roth IRA Contribution Limit Rules
- Roth IRA Distribution Rules
- Roth IRA Conversions
- Deductible and Non-Deductible Traditional IRAs
- Roth IRA Conversion Process
- Taking Advantage of Roth Conversions (Timing is Everything!)
- Who is Eligible for Roth IRA Conversions?
- Two Options for Converting Traditional IRAs into Roth IRAs
- Comparing Roth IRAs to Other Retirement Plans
- Comparing Roth IRA to Traditional IRA
- Comparing Roth IRA to Traditional 401k
- Where to Invest – 401k or IRA?
- How Many Retirement Accounts Can You Have?
- Who Should Open a Roth IRA?
- How to Open a Roth IRA
- Getting Started with a Roth IRA
- How to Invest Your Roth IRA Funds
- Maximize Your Roth IRA Contributions
- Once You Go Roth, You Never Go back
Roth IRAs are among the best retirement investment vehicles. They allow investments to grow tax-exempt until retirement age and offer tax-free withdrawals.
You may have heard about a Roth IRA.
It’s one of those terms that frequently gets bandied about on TV or the radio. And with good reason, a Roth IRA is an investment account that is among the best ways to prepare for retirement.
Roth IRAs are tax-advantaged individual retirement accounts that offer varied investment opportunities and exceptional tax benefits.
Individuals can make contributions with after-tax dollars into an investment account where the contributions grow without the drag of taxes. They can be withdrawn tax-free in retirement at age 59 ½ or later.
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 in retirement.
To top it off, there are no required minimum distributions (RMDs), meaning you don’t need to make withdrawals.
This is advantageous when you reach retirement age. You can withdraw investments without paying additional taxes or defer withdrawals until you are ready.
Roth IRA – One of the Best Retirement Tools
Retirement planning is something everyone needs to do. Even if you serve in the military long enough to earn a retirement and pension, it might not be enough for your golden years.
Everyone needs to take retirement planning into their own hands, and retirement accounts such as the Thrift Savings Plan, 401(k) plans, and IRAs are a great way to do that.
Types of IRAs, and Why a Roth IRA Rules
Two types of IRAs are available to most people – traditional IRAs and Roth IRAs. While similar, there are differences in paying taxes on contributions and withdrawals.
Here is a primer about 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.There is also a special provision for military members. The Heroes Earned Retirement Opportunities (HERO) Act allows military members with tax-free combat pay to contribute to Roth IRAs and other retirement plans.
2022 Roth IRA Income Limits
There is a cap on how much you can earn and contribute to a Roth IRA.
For the 2022 tax year, Roth IRA eligibility begins phasing out at an annual modified adjusted gross income (MAGI) of $129,000 for single tax filers. Single tax filers are ineligible to make Roth IRA contributions when their income reaches $144,000. The limits are higher for married filing jointly, with eligibility phasing out starting at $204,000 and ending at $214,000.
The following table breaks down Roth IRA income limits:
| Filing Status | Modified AGI | Allowable Contribution |
|---|---|---|
| Married filing jointly or qualifying widow(er) | $204,000 or less | Up to the annual contribution limit |
| more than $208,000 but less than $214,000 | Partial amount | |
| $215,000 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 | $129,000 or less | No contribution |
| more than $129,000 but less than $144,000 | Partial contribution | |
| $144,000 or more | No contribution |
What to Do if Your Income Exceeds Roth IRA Contribution Limits
The tax advantages for IRAs are generous. Because of that, 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 still contribute to a non-deductible traditional IRA and convert it to Roth IRA at a later date. 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 contribute to your Roth IRA.
If you meet income requirements, then you can contribute up to $6,000 if you are younger than age 50, or $7,000 if you are age 50 or older. (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.
It is important to note the limits apply for all IRAs opened during the specific tax year. Since you can open both traditional and Roth IRAs in the same year, be careful not to exceed contribution limits across both accounts.
The following chart shows IRA contribution limits for 2002-2022.
| Tax Year | Contribution Limit Age 49 or Younger | Catch-Up Contribution Limit Age 50 or Older | Contribution Limit Age 50 or Older |
|---|---|---|---|
| 2019 - 2022 | $6,000 | $1,000 | $7,000 |
| 2013 - 2018 | $5,500 | $1,000 | $6,500 |
| 2008 - 2012 | $5,000 | $1,000 | $6,000 |
| 2006 - 2007 | $4,000 | $1,000 | $5,000 |
| 2005 | $4,000 | $500 | $4,500 |
| 2002 - 2004 | $3,000 | $500 | $3,500 |
Roth IRA Distribution Rules
Distributions are among the main benefits of using a Roth IRA instead of a traditional IRA. As previously mentioned, distributions from Roth IRAs are tax-free, whereas traditional IRA distributions are taxable.
Roth IRAs have an added benefit over traditional IRAs because there is no required minimum distribution age with a Roth IRA.
There are other rules and considerations to be aware of.
First, you can withdraw contributions at any time, tax-free and penalty-free. But 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 59 ½ years old.
This is called the five-year rule.
Exceptions for early Roth IRA withdrawals. Other Roth IRA withdrawal rules may apply to your situation. 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 or 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
Should you consider a Roth IRA Conversion?
Moving money held in 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 taxable income. The lack of required minimum distributions also gives Roth investors more long-term flexibility.
Deductible and Non-Deductible Traditional IRAs
There are two types of conversions: conversions from deductible traditional IRAs and non-deductible traditional IRAs.
Deductible IRAs are those where you deduct the contribution on your taxes. Non-deductible IRAs are those without a corresponding tax deduction.
These are common for people whose income exceeded the traditional IRA and Roth IRA income limits.
Contributing to a non-deductible IRA still allows contributions to an IRA during the tax year. This is often used by people who want to do a back-door Roth IRA (contributing to a non-deductible IRA, then immediately converting it into a Roth IRA).
Roth IRA Conversion Process
During the conversion process, the money rolled over from a traditional IRA into a Roth IRA is added to your annual taxable income for that year. This is taxable income because you did not pay taxes on contributions or earnings. The IRS still needs to assess taxes on that income and gains. So you pay when you convert and file your taxes the following year.
Non-deductible IRA conversions are not considered taxable income. So you do not pay taxes on the contribution amount. However, you pay taxes on any non-deductible IRA gains.
Many who take advantage of Roth IRA conversions using non-deductible IRAs convert the non-deductible IRA as soon as possible to avoid taxable gains. This is called a back-door Roth IRA.
Important note: The pro-rata rule. The IRS requires taxpayers who convert a traditional IRA to a Roth IRA to convert them on a pro-rata basis. That means you can’t just convert only non-deductible IRAs to a Roth IRA if you also have deductible IRAs. You must convert them proportionally. This is done so the IRS receives taxes at the time of conversion. This is an advanced matter, and one 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 makes it possible to 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; those are non-taxable.
Investors currently in a low tax bracket often invest using 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.
Paying taxes on money in a lower tax bracket saves overpaying taxes later in a higher bracket.
Many 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?
You must meet eligibility requirements for converting a traditional IRA into a Roth IRA:
- 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.
- You can convert a portion of the traditional IRA into a Roth IRA, not just the non-taxable part.
Two 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 contact the bank or broker who manages your traditional IRA and instruct them 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 full amount plus penalties if you are younger than age 59 ½.
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 can not keep some money as cash or to take a vacation.
Comparing Roth IRAs to Other Retirement Plans
Roth IRAs offer different benefits compared to other retirement plans or taxable investments that don’t offer tax benefits. 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 the name, where you can open them, and often how much you can contribute to them (there are 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).
But there are also different factors 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 of your investments.
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 the qualified distributions, or withdrawals, are tax-free.
The next major difference is how and when you make withdrawals. Traditional and Roth IRAs list age 59 ½ as the minimum age requirement for penalty-free withdrawals.
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 a required minimum distribution. You can read more information about these two plans in the article: Comparing Roth IRA vs Traditional IRA.
Comparing Roth IRA to Traditional 401k
Some companies offer both Traditional 401k plans and Roth 401k plans. The Roth 401k has similar benefits to a Roth IRA but follows the contribution limits for 401k plans. Traditional 401k plans are closer to a Traditional IRA and offer a current tax deduction but are taxed when withdrawn in retirement age. All 401k plans also have a required minimum distribution age. Unlike a Roth IRA, the Roth 401k requires participants to take RMDs once they reach the required age.
Where to Invest – 401k or IRA?
One of the most common questions is where to invest first – 401(k) or IRA. For most people, a Traditional 401k plan is better if their employer offers a company match on their investment.
Take the free money, then contribute to the Roth IRA if you can afford to contribute beyond that. I encourage you to read these articles for a more in-depth comparison between Roth IRAs and Traditional 401k plans.
See also: Should You Contribute to a 401k Without an Employer Match?, which addresses the issue of contributing to a Roth IRA if your company does not offer a 401k match (in this case, a Roth IRA probably offers more flexibility).
How Many Retirement Accounts Can You Have?
You can have many retirement accounts. It is common for people to have employer-sponsored retirement plans such as a 401k, 403b, or Thrift Savings Plan, IRAs, and sometimes other retirement plans such as a self-employed retirement plan.
You can also have IRAs at multiple financial institutions. However, they are considered to be one IRA for tax purposes (meaning you can’t exceed contribution limits in any given year by opening multiple IRA accounts with other banks or brokerages). For more information, read: How Many Retirement Accounts Can You Have?
Who Should Open a Roth IRA?
I think the Roth IRA is a great investment option and should be considered by anyone eligible to open a Roth IRA. A Roth IRA is a great deal for people currently in a lower tax bracket than they anticipate they will be in later in life. The advantage for them is paying taxes at a low tax rate now, then making tax-free withdrawals when they reach retirement age and may be in a higher tax bracket.
Why young people should open a Roth IRA
I took this situation further and compared Traditional and Roth IRAs for younger investors. The idea is that many people in their youth are in a lower tax bracket than they will likely be in the future as the income potential for most people grows with time.
Why military members should open a Roth IRA
Military members have the opportunity for several specific benefits from Roth IRA plans that civilians do not have, including the ability to make tax contributions if they served in a tax-free war zone and make tax-free withdrawals at retirement age (tax-free contributions, growth, and withdrawals!).
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. Here is more information: Military Members Should Open Roth IRAs.
How to Open a Roth IRA
All of this sounds great, right? So are you ready to open your first Roth IRA?
Good.
Opening a Roth IRA is easy and takes only 10-15 minutes. All you need to do is go to the bank or brokerage company you wish to do business with, fill out some paperwork, initiate a money transfer, and you are done. Of course, it is important to do some research first, and the following articles will help you get the necessary information to open the best Roth IRA for your needs.
Getting Started with a Roth IRA
As mentioned above, opening a Roth IRA is just a 10-15 minute process. If you read the articles listed above, you should have a good idea of the benefits of a Roth IRA, why you should open a Roth IRA, what to look for in a Roth IRA, and some of the best places to open a Roth IRA.
Now you just need to get started!
How to Invest Your Roth IRA Funds
I can’t tell you how to invest your money – that is a personal decision that should be based on 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 want investments that will grow more over time. Remember, you won’t pay taxes on any growth in the funds in your Roth IRA. So you want to maximize your growth potential in your Roth IRA.
Conversely, you can consider investing in funds with lower growth potential in your Traditional 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 make adjustments 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 current maximum contribution limit for a Roth IRA is $6,000 per year.
Most people can’t contribute $6,000 at once, which is OK. A great way to invest the most money you can is to set up automatic investments in your Roth IRA account.
Determine how much you can contribute each month and automatically send in that amount. If you want to max out your Roth IRA contributions each year, you must contribute $500 per month.
Benefits of Automatic Contributions
Making automatic contributions will guarantee that you contribute each month instead of writing a check each month, which creates the opportunity for forgetting or deciding not to invest.
You will also take advantage of dollar cost averaging, which can be a great way to invest over long periods. Dollar cost averaging ensures that you will buy more investments when values are low, and fewer when values are high, hopefully averaging out in your favor in the long run.
Once You Go Roth, You Never Go back
The prospect of having a tax-free nest egg in retirement is very attractive, and something you won’t want to pass up. There aren’t many opportunities for tax-free income, especially when it comes to investments. The longer you have before retirement age, the more time you have for compound interest to increase your nest egg. If you are eligible, consider a Roth IRA, and max out your contributions each year.
Comments:
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Alvin R says
“you must have also left your contributions in the Roth IRA for a minimum of 5 years before you can make the withdrawal, otherwise they may be subject to a 10% early withdrawal penalty.”
Clarification: you may withdraw your CONTRIBUTIONS to a Roth IRA at any time free from tax and penalty. There is no 5 year wait for your Roth IRA CONTRIBUTIONS.
Ryan Guina says
Thank you, Alvin. I have updated the section regarding the 5 year rule. I appreciate it!
Deacon says
I agree. Tax-free growth is a great way to go. Keep up the good work!
Smart Military Money says
Ryan,
Outstanding piece. The Roth IRA is overlooked too often.
In the coming years, do you think young veterans will take advantage of Roth IRAs more than previous generations of veterans?
Ryan Guina says
I hope so, especially with the government talking about changing military retirement benefits.