What are the benefits of a Roth IRA and how do these accounts work?

A Roth IRA is an Individual Retirement Account to which you contribute after-tax dollars. With a Roth IRA account, you won’t pay taxes as your money potentially grows, and you can make tax-free withdrawals during retirement. The reason these plans are so important is that they combine the power of compounding with the benefit of tax-free growth. Generally speaking, you can fund a Roth IRA account in addition to a 401(k) or SEP IRA retirement plan. The contribution limits for a Roth IRA are separate from the contribution limits for a 401(k) or SEP IRA. These plans aren’t offered through employers but can be set up fairly easily.

The process of deciding when and how to use Roth accounts and what the size of your Roth accounts should be relative to your pre-tax retirement accounts is a balancing act for most.  Factors that may influence this decision include your age, life expectancy, the size of your assets, tax bracket (today and projected for future), income level, budget (income needs), as well as a host of other circumstances.  We don’t always know what the future holds and having both types of retirement accounts can serve to help you increase your savings over time and provide a lot of additional flexibility. Because everyone has a different situation and there are many strategies to choose from, there are many areas of opportunity where a Roth account may be beneficial.

You have until tax day in mid-April 2025 to complete a 2024 Roth IRA Contribution. If you’re married filing jointly or a qualifying widow(er): If your modified AGI is less than $230,000, then you are able to contribute up to the $7,000 contribution limit ($8,000 if you’re age 50 or older) in 2024. If your modified AGI is between $230,000 and $240,000, you are eligible to contribute, but you’ll have a reduced limit. The value of that limit is calculated using a formula based on your AGI and filing status. If your modified AGI is higher than $240,000, you are unable to directly contribute to a Roth IRA that year.If you’re single, a head of household, or married filing separately and you did not live with your spouse at any time during the year: If your modified AGI is less than $146,000, you’re able to contribute up to the annual limit, and if your modified AGI is between $146,000 and $161,000, you’ll be held to a reduced limit. You’d be ineligible to contribute directly contribute to a Roth IRA in 2024 if your modified AGI is over $161,000.

If you earn more than the respective limit for your tax filing status, then you are not permitted to make Roth IRA contributions and the Backdoor Roth IRA structure will have to be employed. The Backdoor Roth IRA process involves making non-deductible traditional IRA contributions and then converting them to a Roth IRA. That’s why they are called “backdoor IRAs,” because your entry point is not through the normal “front door.” Roth strategies can help you reduce Medicare costs / premium surcharges in the future known as the income-related monthly adjustment amount (IRMAA).

Who are Roth IRAs best for? What type of consumers should consider them over other options?

A Roth IRA can be a good savings option for those who expect to be in a higher tax bracket in the future, making tax-free withdrawals even more advantageous. You can contribute at any age to a Roth IRA as long as you have a qualifying earned income. Also noteworthy, if you pass your Roth IRA onto your heirs, their withdrawals will also be income tax-free.

Probably the best way to accumulate funds for retirement is to take advantage of IRAs and employer retirement plans. The reason these plans are so important is that they combine the power of compounding with the benefit of tax-free growth. For most people, it makes sense to maximize contributions to these plans, whether it’s on a pre-tax or after-tax (Roth) basis. A key part of a tax planning strategy is to reduce the taxes from withdrawn funds from tax-deferred accounts, such as 401(k)s or IRAs.

Whether or not you can make contributions to a Roth IRA depends on your tax filing status and your modified adjusted gross income (MAGI). High income professionals do not qualify to make Roth contributions. Back-door Roth IRA’s allow you to make non-deductible traditional IRA contributions and then convert them to a Roth IRA.

Don’t Forget to Also Consider a Roth Conversion Strategy

One effective strategy that many overlook is converting previously funded tax-deferred funds to a Roth IRA or Roth 401(k). While the conversion amount is taxable in the year it is converted, the upside is these Roth accounts let your retirement savings grow tax-free and are not taxable when withdrawn (as long as you’re 59½ or older and have owned a Roth for at least five years).  It will be necessary to work with your accountant on this to ensure that the conversions do not inadvertently move you up to the higher tax bracket (this calculation will be based on your adjusted gross income each year, so conversions should be assessed after your taxes are prepared for each calendar year).

How do Roth IRA withdrawals work? Can you pull money out at any time?

There is no need to take required minimum distributions with a Roth IRA (unlike a Traditional IRA). Withdrawals can be taken out tax-free and penalty free, provided you’re age 59½ or older and you have met the minimum account holding period (currently five years).  You can be assessed a 10% early withdrawal penalty if you don’t follow the guidelines. There are exceptions to the early withdrawal penalty, such as a first-time home purchase, college expenses, and birth or adoption expenses.

Are there any downsides to Roth IRAs?

There are no current-year tax benefits for Roth IRA’s as there are with many other types of retirement accounts.  So these accounts don’t serve to reduce your upfront taxes like other retirement accounts do.  It’s important, however, not to let the upfront tax bill prevent you from moving your retirement funds from accounts that are taxed no matter when you take them out into accounts that are tax-free. The point is to not be shortsighted at the expense of being hit with large tax payments in retirement.