Understand Roth IRAs and Use Them for Your Advantage

Senator William Roth - Roth IRA Rules

The late Senator William V. Roth, Jr.

The traditional individual retirement account (IRA) has long been a savvy way to do some tax-deferred investing for retirement. Though the Roth IRA was established by the Taxpayer Relief Act of 1997 and named for Delaware Senator William Roth (who was a key player in the Act), this retirement vehicle is still not quite as well-known or understood as the traditional counterpart.

The Roth IRA is an Individual Retirement Account that allows you to invest in securities (usually stocks and funds) and it works in contrast to a traditional IRA, from a tax structure perspective. You invest in a Roth IRA using dollars that have already been taxed. And qualifying distributions are made tax-free. Pay tax now, don’t pay it later.

Understanding the pros and cons of investing with pre-tax vs post-tax dollars can help investors figure out the best way to plan for their retirements. And making sure you are clear on the rules and requirements for Roth IRAs can help find the right strategy and workarounds that will allow you to enjoy the benefits of this vehicle without getting on the IRS’s naughty list.

Here’s what you need to know about how a Roth IRA can fit into your retirement plan and what you can do to take advantage of this retirement vehicle.

Roth IRA Rules

There are several rules and qualifications that investors must meet to take advantage of a Roth IRA. To start, there are the contribution limits and income limits:

Roth IRA Contribution Rules

You are allowed to contribute $6,000 per year to the Roth IRA (in 2020). If you are age 50 and up, that number rises to $7,000. You can make these contributions up until you file your taxes. Therefore, for 2020, you’ve got until April 15, 2021 to contribute the $6,000 to your Roth IRA.

Income Rules for the Roth IRA

Uncle Sam doesn’t let income earners above a certain level contribute to IRAs, and that’s true of both the traditional and Roth flavors. To be eligible to contribute, your income must be below the following limits (for 2020):

  • Filing Single: Up to $124,000 (full contribution); $124,000-$139,000 (to be eligible for a partial contribution)
  • Filing Jointly: Up to $196,000 (full contribution); $196,000-$209,000 (to be eligible for a partial contribution)

Roth IRA Conversion Qualifications

Though higher-income investors are shut out of the Roth IRA, there is a workaround that can get you the benefits of a Roth IRA without running afoul of the IRS. This is through a Roth IRA conversion.

Here’s how it works: prior to 2010, if you had money in a traditional IRA, you couldn’t convert it to a Roth IRA if you made more than $100,000 AGI. As of 2010, the law changed so that you can now convert your traditional IRA funds to a Roth IRA regardless of income.

What if You Don’t Qualify for a Roth IRA: Check the Backdoor

If you make too much to contribute to a Roth IRA, the option to convert a traditional IRA into a Roth IRA is known as a backdoor Roth. Here’s how the backdoor works:

  1. First, you contribute funds to a non-deductible traditional IRA, and then
  2. You convert that IRA over to a Roth IRA.

Your broker or mutual fund company should be able to handle all of this for you with a couple of phone calls. You’ll also need to keep track of your moves though for tax reporting.

Sound simple? Not so fast. There are some important aspects of a backdoor Roth that you’ll have to consider:

An Example of the Backdoor Roth IRA Contribution

The annual contribution limit on your IRAs is $6,000. So let’s say you attempt this backdoor move and first contribute the max, $6,000, to a non-deductible traditional IRA.

This can be done fairly quickly these days. Robo Advisors like M1 Finance allow you to set up a non-deductible traditional IRA with the click of a few buttons. You can fund your non-deductible traditional IRA, and once the transaction is complete, request the conversion to a Roth IRA.

Read our full review of M1 Finance!

The Pro-Rata Rule and How to Get Around It

Where this gets tricky apparently is in the conversion. When you make a conversion, you have to consider all the money in all of your traditional IRAs as being in one bucket. So, regardless of your current year non-deductible traditional IRA contributions, you may have to pay taxes on your conversion if you have ever made deductible traditional IRA contributions.

For example, let’s say I have $18,000 in a deductible traditional IRA. I made these contributions a few years back when I didn’t have access to a company 401(k). Now, this year, I’ve decided to try to complete the backdoor Roth IRA.

First I’d contribute my $6,000 to the non-deductible IRA. Then I’d go to make the conversion. When I convert my $6,000 I’ll have to consider all $24,000 ($18,000 + $6,000) in the move. Since 75% of my balance is tax advantaged, I’ll have to pay taxes on 75% of my conversion. So, $4,500 of my current year conversion will be taxed as income.

This requirement on the conversion makes the decision a bit tougher for people who already have traditional IRA account balances. But according to Ashlea Ebeling writing for Forbes.com there is a way around this “pro-rata” rule.

“So how do you remove the pretax IRA from the equation? Transfer it to a 401(k). Many employer plans allow “roll-ins” of IRA money to 401(k)s.”

Ah, sneaky, sneaky. I actually just opened a Solo 401(k) with Vanguard so I may look into doing one of these roll-ins with my old traditional IRA, even if a backdoor Roth IRA contribution isn’t in my future. If you’re interested in avoiding the pro-rata and would like some hands-on help with this kind of account activity, the Vanguard Personal Advisor Service platform offers access to human advisors.

Read our full review of Vanguard Personal Advisor Services!

Is a Roth 401(k) Conversion Right for You?

Speaking of 401(k) accounts, as of 2013, investors have the ability to convert assets in tax-deferred accounts, such as 401(k) and 403(b) retirement accounts, into a Roth 401(k) account.

Like a Roth IRA, a Roth 401(k) allows investors to contribute post-tax dollars that grow and can be withdrawn tax-free in retirement. But Roth 401(k) accounts have higher contribution limits ($19,500, rising to $26,000 for savers over age 50 in 2020) and there are no income limits for contributing. This makes a Roth 401(k) an attractive option for higher-earning investors who want to reduce their tax burden in retirement.

Unfortunately, a 401(k) conversion has some of the same potential problems as a backdoor Roth IRA. If you decide to convert your tax-deferred traditional 401(k) into a Roth 401(k), then the total amount of your rollover is fully taxable in the year of that conversion. For those who have healthy 401(k) balances, that could result in a nasty tax bill in the here and now.

Mitigating the Taxes of a 401(k) Conversion

If you do decide to convert to a Roth 401k account, you will have to make sure you have the cash on-hand to pay the tax due in the year of conversion. Otherwise, you might have to dip into the retirement account itself in order to pay your tax bill, which will result in an early-withdrawal penalty of 10% of the amount withdrawn.

One way of lowering your tax bill in the year of your conversion is through strategic charitable giving. Giving a sizable financial gift to charity will offset your increased tax burden, which can help to make the conversion more affordable. Of course, this only works if you are already in the habit of large donations to charity. Otherwise, this strategy will simply be exchanging one large cash outlay for another—and depending on your tax liability, it may not completely offset your increase in taxes.

See also: 7 Strategies to Save You Thousands Each Year in Taxes

Another way of maximizing the benefits of conversion without unduly hurting your current taxes is to only convert a portion of the money in your 401(k) into a Roth 401(k). This will provide you with some tax-free income in retirement, without overburdening your current ability to pay taxes.

Who Can Do a Roth 401k Conversion?

Unfortunately, the Roth 401(k) conversion option is not available to all workers. Your employer will have to decide to offer this option, even though all plan sponsors (that is, employers), now have the right to amend their plans to include such Roth 401(k) conversions.

However, it’s a good idea to talk to both your plan administrator and your HR department to find out if and when your employer will make the amendment to their plan. The more people who ask about this, the more likely employers it is that will be encouraged to make the conversion available to their employees.

If you don’t have a financial planner, you may need professional guidance regarding your financial future and your 401(k) account. Blooom can help to give you quality advice for your 401(k) program.

Read our complete Blooom review here!

Roth IRA FAQ

Make sure you understand the answers to some common questions about Roth IRAs:

1. Is a Roth IRA an investment?

No. A Roth IRA is an account. Not a specific investment. A Roth IRA is simply an account to put your investments, things like stocks, bonds, and cash.

That means you get to decide which asset classes you want in your Roth IRA account–and that includes alternative asset classes, if you so choose.

2. How does a Roth IRA work?

After you open a Roth IRA you are allowed to make after-tax contributions into the account and then choose investments. You can withdraw those contributions at any time.

However, since that money is typically invested and those earning are growing tax-free, the money you earn on your contributions generally cannot be withdrawn until you reach 59 and a half. The Roth IRA withdrawal rules can be complicated so be sure you understand them before getting started.

Read more: 5 Things to Know About Roth IRA Withdrawals

3. Who should open a Roth IRA?

A Roth IRA is perfect for anyone just getting started with retirement investing who wants to pay fewer taxes on the money they use in retirement. They are also good for those who have a retirement plan through work (like a 401(k)), but want to make additional retirement contributions.

The Roth IRA is also good for anyone wanting more control over their retirement investing options.

4. Can you contribute to both a 401(k) and a Roth IRA?

Yes, in most cases this can be done. In fact, I would encourage you to do both if you have the choice. When I met the eligibility rules I was contributing the max to my 401(k) and then started contributing to the Roth IRA with my remaining dollars.

5. How do you open a Roth IRA?

There are lots of places to open a Roth IRA. Robo Advisors like Betterment can be an excellent place to start your Roth IRA. As an online financial advisor and broker, Betterment offers you an easy way to open, begin funding, and diversify your Roth IRA.

Read our full Betterment review here!

Whether you choose Betterment or another online broker or Robo Advisor for your Roth IRA, the process for opening the account is very similar to opening a savings account. You will provide some basic personal information and fund the account with an initial deposit. There is typically a “cash” type fund where you can hold your initial deposit while you decide on particular investments.

6. How much can you contribute to a Roth IRA?

The annual contribution limit changes each year, but in 2020 the contribution limit is $6,000 per individual, with those 50 or older getting an extra $1000 added to their limit. There are also income limitations: single filers must earn less than $124,000 and married couples filing jointly must earn less than $196,000 to be able to make a full contribution to their Roth IRA.

Personal Capital can be really helpful in making sure you stay clear of the income limitation rules while ensuring you contribute as much as you can. Not only does Personal Capital help you manage all of your money (including your income and net worth) with free budgeting and aggregation tools, but it also can help you with investment decisions.

Read our full Personal Capital Review here!

7. What investments do you choose for your Roth IRA?

This is a very personal decision that should be based on your own tolerance for risk and understanding of basic investing concepts like asset allocation and diversification. I typically invest in low-cost target date mutual funds or some type of index mutual fund.

If you choose to open a “self-directed” Roth IRA you can invest in a number of different things, like real estate, peer lending notes, and even precious metals.

For instance, Alto is a broker that allows you to use the retirement funds in your Roth IRA to invest in private equity, venture capital, real estate, cryptocurrency, and more.

In addition, Rocket Dollar allows investors to use their Roth IRA to invest in just about anything–as long as it’s allowed by the IRS–including such asset classes as real estate, precious metals, or startups.

8. Can I rollover an old 401(k) into a Roth IRA?

Yes. As long as you’ve left the job, you can transfer funds directly from your 401(k) into a Roth IRA. Note that you will need to ensure that “direct” transfer takes place.

Also, note that you will need to pay the income taxes on the money you are transferring since the tax treatment of the money in changing.

9. What are the contribution and income limits for Roth IRAs?

As of 2020, the maximum that those under age 50 are able to contribute to a traditional or Roth IRA is going to be the lesser of $6,000, or the dollar amount of how much you made (your taxable compensation) for the year. For those who are 50 or older, you can contribute the lesser of $7,000 or the dollar amount of how much you made (your taxable compensation) for the year. In either case, you can’t contribute more than you earned.

In addition, you can have multiple IRAs. You can have as many traditional and Roth IRAs as you would like. However (and this is the important part) your contribution limits are applied to your contributions across all accounts.

For example, let’s say you have a traditional IRA, a traditional (Rollover) IRA, and a Roth IRA. You can only contribute up to the limit, split across all accounts in total. That means if you contribute $5,000 to your Roth IRA this year and $1,000 to your traditional IRA, you would not be eligible to contribute any money to your Rollover IRA in 2020.

To contribute the maximum to a Roth IRA, your income must be below $124,000 for singles and below $196,000 for married couples filing jointly. If you make over $139,000 as a single filer or $206,000 as a married couple filing jointly, then you can’t contribute anything directly to a Roth IRA, although you can still take advantage of a backdoor Roth IRA in that case.

10. What is the deadline for making your Roth IRA contribution?

You have until the day you file your taxes for the year to contribute to your Roth IRA. That means your contribution deadline is the last day to file taxes. In most years that is April 15 (or thereabouts, if the 15th falls on a weekend). In 2020, the tax filing deadline for 2019 taxes was extended to July 15, 2020 because of the Coronavirus crisis.

See also: The Last Day to File Taxes (and What to Do If You Can’t Pay)

Do you have plans to take advantage of a Roth IRA?

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About Philip Taylor, CPA

Philip Taylor, aka "PT", is a CPA, blogger, podcaster, husband, and father of three. PT is also the founder and CEO of the personal finance industry conference and trade show, FinCon.

He created Part-Time Money® back in 2007 to share his advice on money, hold himself accountable (while paying off over $75k in debt), and to meet others passionate about moving toward financial independence.

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  1. It was named after a real “Roth”?! Haha that is awesome….that guy’s a baller. Good stuff my man, as always.

  2. @Mike “Do you have any idea why Congress saw fit to put this limitation in place?”

    So that this would be seen as a tax break for the middle class, and not the rich. It’s progressive taxation. i.e. the rich make enough already, they can handle their own retirement needs without tax breaks.

    My questions was somewhat rhetorical. If you poke around this blog enough you can see I’m not a fan of progressive taxation. It’s simply not fair. And I’m not even a rich guy.

    This bill was passed back in 1997. Clinton had just won his second term, but the Republicans ran the Congress. I suspect the income limit was a Clinton administration injection in exchange for signing the thing.

  3. Mike Dunham says

    “Do you think it’s a good idea to have income limits on Roth IRA contributions?”

    I’m always hesitant to answer questions like this without knowing the policy reason for the limit. Do you have any idea why Congress saw fit to put this limitation in place?

    To answer the question, though, since there is a limit to how much can be contributed, I would think there is no useful purpose served by disallowing higher-income households to take advantage of this.