The world of retirement savings is often complicated and murky, chock full of Social Security benefits, annuities, 401(k) plans, and so much more. Today, we're going to explore the hidden power of Roth IRAs, learning how they work and who they’re best for.

IRAs, defined

An IRA (individual retirement arrangement) is an account that features various tax benefits and is designed specifically to help fund your retirement. You can also invest in many different assets within the account including stocks, bonds, ETFs, and mutual funds. While many different types of IRAs are available, traditional and Roth IRAs are the two most common options.

Traditional vs. Roth IRAs

One of the biggest differences between these two IRAs is with respect to taxes; taxes are deferred with traditional IRAs—meaning you’ll pay them on a future date—while you do so upfront with Roth IRAs.

More specifically, traditional IRA accounts are generally funded with pre-tax dollars. In this scenario, you won’t pay taxes on your earnings or principal until you begin making withdrawals. With a Roth IRA, however, you won’t need to worry about paying taxes on withdrawals in retirement since you’re funding the account with after-tax dollars. Earnings can also be withdrawn tax-free—provided you play by the rules (more on that shortly).

Roth IRA income limitations

While Roth IRAs are an excellent way to fund your retirement, they do come with a few challenges—particularly if you’re a high-income earner.

For example, if you are a single filer with a modified adjusted gross income (MAGI) of over $153,000 (in 2023), you are not eligible to contribute to a Roth IRA. If your MAGI is more than $138,000 but less than $153,000, however, you can contribute—but only a reduced amount. These limits will increase to $161,000 and $146,000 respectively in 2024.

The maximum MAGI limit is $228,000 for those filing jointly, based on contribution qualifications. If your joint MAGI exceeds $218,000 but is less than $228,000, your maximum allowed annual contribution is reduced. These limits will increase to $240,000 and $230,000 respectively in 2024.

Backdoor Roth IRAs can help you skirt income limits

If you find yourself exceeding the afore-mentioned income thresholds, feel free to explore an alternative solution—which is precisely where backdoor Roth IRAs (also a type of Roth conversion) come into play.

A backdoor IRA isn’t a type of retirement account but rather a strategy that allows high-income investors to fund a Roth IRA even though their income exceeds IRS limits: requiring that you convert a portion (or all) of your traditional IRA or 401(k) into a Roth IRA.

If you’re considering this route, keep in mind you’ll pay taxes on the money you convert from a traditional IRA and also owe taxes on the money your traditional IRA earned between the time you contributed to it and the date of your Roth IRA conversion. Consequently, this money may count as taxable income and bump you into a higher tax bracket.

Roth IRAs also have contribution limits

Furthermore, if you are under age 50, the maximum annual contribution limit for both traditional and Roth IRAs is $6,500 for 2023 ($7,000 on 2024); those age 50 or older can contribute an additional $1,000 (limits do change annually). This extra $1,000 is known as a “catch-up” contribution, with this amount expected to be adjusted annually for inflation in 2024 based on pending SECURE 2.0 Act legislation.

Keep in mind you can also continue to make contributions for the previous year up until the income tax deadline. In other words, you can make a contribution (any amount, up to the limit) for 2023 up until April 15, 2024.

Roth IRA withdrawal rules

Roth IRA withdrawal penalty rules vary depending on your age, what exactly you’re withdrawing (e.g., contributions versus the earnings portion of your account balance), and how long you’ve had the account.

With Roth IRAs, you can withdraw sums equivalent to contributions you’ve made both penalty and tax-free—at any time and for any reason. If you’re over the age of 59½ and want to withdraw from the earnings portion of the account, you can do so tax-free provided you’ve owned the account for at least five years (known as the “five-year rule”).

However, if you withdraw from the earnings portion of your Roth IRA any earlier, know you’ll likely face a 10% early withdrawal penalty and be required to pay taxes on these earnings. That said, there are exceptions to every rule—and Roth IRAs are no different!

For example, if you’ve owned your Roth IRA for less than five years and are younger than 59½, you can avoid the early withdrawal penalty if the following situations apply to you (keeping in mind you’ll still be subject to taxes in any of these scenarios):

·      You use the withdrawal to pay for unreimbursed medical expenses exceeding 7.5% of your adjusted gross income for the year

·      You’re unemployed and are taking a distribution to pay for health insurance premiums

·      You use the withdrawal to pay for qualified education expenses

·      You use the withdrawal to fund a first-time home purchase (up to $10,000)

·      You use funds for qualified expenses related to a birth or adoption

·      You become disabled

·      You’re a beneficiary following the death of the account owner

·      You make the distribution in substantial (and equal) periodic payments (otherwise known as a “SEPP”)

Note that the new SECURE Act 2.0 will expand these circumstances to include emergency expenses and domestic abuse.

If you’ve owned your Roth IRA for more than five years and are younger than 59½, you can avoid the 10% early withdrawal penalty and avoid taxes in various circumstances including:

·      Using the withdrawal to fund a first-time home purchase (up to $10,000)

·      You become disabled

·      You’re a beneficiary following the death of the account owner  

Finally, if you’re age 59½ or older and have owned your Roth IRA for less than five years, you’ll owe income tax but won’t need to pay a penalty on earnings you withdraw.

Roth IRAs aren’t subject to RMDs

Required minimum distributions (RMDs)—the amount of money you have to withdraw from the account every year after turning 73—accompany traditional IRAs. Roth IRAs, meanwhile, are entirely exempt from RMDs: meaning the money in your account can continue to grow for as long as you’d like.

Roth IRAs can be inherited tax-free

If you pass away before exhausting your Roth IRA funds, you can pass the account onto your designated beneficiary or next of kin without the need to go through probate. This is true for both Roth and traditional IRAs; but with a Roth IRA inheritance, heirs can typically withdraw their money tax-free over a ten-year period (spouses, minors, chronically ill individuals, and disabled children can treat an inherited Roth IRA account as their own and aren’t limited to this ten-year window).

If you participate in a 401(k), you might be required to contribute to a Roth IRA version in 2026

If you earn more than $145,000 from an employer in 2025 and contribute to an employer-sponsored plan—such as a 401(k), 403(b), or 457(b)—you must make catch-up contributions to a Roth version of your respective retirement plan beginning in 2026: meaning you’ll pay taxes on your catch-up money upfront rather than contributing pre-tax money, as you can now. However, you won’t need to pay taxes on the money or its earnings when you withdraw later in life—and if your employer doesn’t offer a Roth version of your plan, you can’t make any type of catch-up contribution to the same. Beginning in 2024, RMDs will no longer be required for these Roth accounts.

How to open a Roth IRA

You can open a Roth IRA at almost any bank, credit union, or other financial institution—with

the former two options most likely taking shape as an IRA Certificate of Deposit (CD), which is often a solid option for people looking to minimize risk and guarantee their return.

Alternatively, you can also open a Roth IRA through your financial advisor or online brokerage: thus enjoying the ability to choose your investments and potentially see higher returns (albeit with more risk).

Just note you need to have  earned income—such as wages, salaries, and other taxable employee compensation—to open and contribute to a Roth IRA. 

In sum: Roth IRAs

While a Roth IRA is a popular and wise investment choice for most people, you’ll need to evaluate how this option fits into your overall retirement plan—circumstances ripe for professional CFP® guidance!

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.