By Katie Cuccia Hebert
It is best to begin contributing to a Roth IRA as soon as possible, but there are benefits to establishing a Roth at almost any age. A Roth IRA provides a way for assets to grow tax-deferred and be withdrawn tax-free if certain guidelines are met.
Roth IRAs are funded with after-tax dollars and do not provide a tax deduction in years you make a contribution. While owning this type of retirement plan account has benefits, you should know the guidelines and limitations before funding a Roth IRA.
Five-Year Rule
While the early withdrawal penalty of 10% applies to distributions prior to age 59 ½, the Roth IRA must meet the five-year holding period rule for Roth earnings to be withdrawn tax-free, regardless of your age.
This means that the money you put into a Roth IRA must be in the account for five years for the earnings to be withdrawn tax-free. The holding period begins January 1 of the taxable year of the earlier of the first Roth IRA contribution or the first Roth IRA conversion.
For example, you cannot open a Roth IRA in March 2020 at age 58 and begin withdrawing the earnings tax-free at 59 ½; you must wait until January 2025 at age 63, after the five-year holding period has passed to qualify for tax-free distributions on earnings.
The account needs to be open for only five years; you do not need to make annual contributions during that time to meet the holding period, and the holding period does not reset with each contribution you make to the account.
However, if you receive a distribution from the Roth IRA prior to the completion of the five-year holding period, the distribution is considered a recovery of the contributions, which is never subject to income tax or the 10% early withdrawal penalty.
Any withdrawals of earnings or interest before completion of the holding period are taxable, and a penalty may apply.
“Earned Income” Requirement
The 2021 Roth IRA contribution limit is $6,000. If you are 50 or over, an additional $1,000 catch-up contribution is allowed, for a maximum total contribution of $7,000.
A Roth IRA contribution can be made at any age and requires you to have “earned income” from part-time or full-time employment. You cannot contribute more than your earned income for the year.
Social Security income, investment income, and pension income do not count toward the “earned income” requirement.
If, for example, you are 55 years old and have $4,000 of earned income for the year, you can contribute only $4,000 to your Roth IRA, even though the contribution limit for a 55-year-old is $7,000.
Income Limits
The tax benefits and flexibility of a Roth IRA make this type of account very desirable. However, regardless of your age, your modified adjusted gross income (MAGI) must be below a certain threshold to be eligible to make Roth IRA contributions.
For 2021, the Roth IRA married filing jointly (MFJ) phaseout limit is $198,000-$208,000, and the phaseout for single taxpayers is $125,000-$140,000.
Contributions from MFJ taxpayers cannot be made if income exceeds $208,000. If your MFJ income falls between $198,000 and $208,000, contributions are limited/phased out, and you may contribute only a portion of the contribution limit.
The income threshold could be a drawback if you wish to start contributing to a Roth IRA later in life when you may be in your peak earning years and have too much earned income to contribute to a Roth. However, the IRS allows for a strategy to work around this income hurdle, known as a backdoor Roth IRA.
Backdoor Roth IRA
A backdoor Roth IRA allows high-income earners who are not eligible to contribute to a Roth IRA to own and fund a Roth IRA, but it requires a two-step process.
If your income exceeds the limits mentioned in the previous section, you may be able to make non-deductible contributions to a traditional IRA. You can then convert these funds into a Roth IRA in some future year with minimal or no tax consequences.
We recommend you work closely with your financial advisor to evaluate whether this strategy would be appropriate. Some key considerations here include the evaluation of other non-Roth IRA assets as well as the necessity to maintain a special tax form called Form 8606.
Your tax professional will need to track information on Form 8606 to maintain records in order to facilitate a backdoor Roth IRA transaction properly.
Roth Conversions
With this type of strategy, high-income earners convert assets from a non-Roth retirement account, such as a traditional IRA, and pay taxes at their ordinary income tax rate on the amount they are converting to the Roth IRA.
However, it is important to evaluate what tax bracket you are in when you make the Roth conversion and the tax bracket you expect to be in when you begin Roth IRA distributions.
For example, you recently lost your job, and your income will be lower this year; therefore, you will be in the 12% tax bracket instead of the 22% tax bracket. It may be an optimal time for a Roth conversion while your income is lower because once you retire, or begin a new job, you may be in a higher tax bracket.
There are currently no income restrictions that limit converting money from a traditional IRA to a Roth IRA. A Roth conversion can occur at any age, and the 10% early withdrawal penalty does not apply if you are under age 59 ½.
While you may pay higher taxes in the year of conversion, you receive the benefit of tax-free growth.
While many people establish a Roth IRA during their working years, others do not establish one until they are in retirement. If you are in a very low tax bracket in retirement, it may be beneficial to begin converting some of your traditional IRA assets to Roth IRA assets to take advantage of the low tax rates.
This is also beneficial if you inherit an account, as beneficiaries are often in a higher tax bracket than the original account owners.
Converting while in a low tax bracket not only results in paying less in taxes but also locks in paying taxes at the current tax rate. There is no way of knowing what the tax brackets will be in the future, so paying taxes now can eliminate the fear that you will be taxed more on the same amount of money later.
For example, you are in the 12% tax bracket, and you can convert $12,000 from your traditional IRA to your Roth IRA without jumping to the 22% tax bracket and without causing any significant tax consequences (these figures are for example purposes only and will vary depending on your specific tax situation).
Because withdrawals from an IRA are taxed as ordinary income, it is important to evaluate your specific tax situation to ensure the conversion is not causing any significant negative tax consequences.
Employer-Sponsored Roth Retirement Accounts
As an alternative to a Roth conversion, you may contribute after-tax dollars to an employer-sponsored Roth 401(k), Roth 403(b), or Roth 457 plan if this option is available.
With this option, not only can you contribute to an employer-sponsored Roth account regardless of your income, but the contribution limits are significantly higher—$19,500, plus additional catch-up contributions if you are 50 or older.
Employee deferral amounts can also be split between pre- and post-tax retirement accounts.
As an example, you may elect a 10% employee deferral to your 401(k) and allocate 50% of the deferral into the traditional 401(k) to receive a tax deduction and allocate the remaining 50% deferral into the Roth 401(k).
Social Security and Medicare
Unlike traditional IRA or 401(k) withdrawals, withdrawals from a Roth IRA are not considered income. They therefore will not be considered when determining if your Social Security benefits will be subject to taxation.
Roth IRA withdrawals will also be excluded in determining if your income is high enough to sustain paying larger Medicare premiums.
Required Minimum Distributions
In addition to the tax benefits provided, you are not required to withdraw any money from a Roth IRA during your lifetime.
This contrasts with a traditional IRA, which mandates required minimum distributions (RMDs) based on the account value and life expectancy to begin at age 72. RMDs are taxed as ordinary income, and any missed RMD is subject to hefty penalties.
Inheriting a Roth IRA
A Roth IRA not only provides for tax benefits to an account owner during their lifetime, but also provides for greater tax efficiency than a traditional IRA once the assets pass to the account owner’s beneficiaries.
While RMDs are not required while the account owner is alive, once you, as the beneficiary, inherit the Roth IRA, you will be required to begin taking RMDs from the Roth IRA by December 31 of the year following the year of death.
If the five-year holding period has been met, the earnings will not be taxable to you.
The holding period for inherited IRAs begins when the original account owner established the account. As the beneficiary, you do not have to start a new five-year holding period for the earnings to be withdrawn tax-free.
However, if the original account owner died before completing the five-year holding period, and RMDs are required prior to completion of the holding period, the earnings will be taxable to you. The five-year holding period cannot be superseded by death.
Receiving tax-free distributions as opposed to taxable distributions can provide substantial tax savings, as it is common for beneficiaries (i.e., adult children) who inherit IRA assets to be in a higher tax bracket than their parents.
This tax-savings is even more significant with the implementation of the SECURE Act. The SECURE Act requires the beneficiary of an inherited retirement account to liquidate the entire account by December 31 of the year of the 10th anniversary of the decedent owner’s death.
For example, you inherit a Roth IRA and a traditional IRA, each for $1 million. The inherited Roth IRA meets the five-year holding period, your MFJ MAGI is $275,000 (24% tax bracket), and you are withdrawing $100,000 per account per year to have all assets withdrawn within 10 years.
The $100,000 you receive from the Roth IRA is not taxable and has no impact on your taxes. The $100,000 you receive from the traditional IRA is taxable as income and causes you to be in the 32% tax bracket, rather than the 24% tax bracket. Had all the assets been in the Roth IRA, the distributions would not have had any impact on your taxable income.
The Bottom Line
There are several factors to consider when establishing or converting a Roth IRA. Speaking with a financial advisor can help you understand your options and determine which ones are right for you.
If you would like to find out more information or are nearing retirement and want to speak with a financial planner about the steps you should take, schedule a complimentary 30-minute discovery call with one of our CERTIFIED FINANCIAL PLANNER™ professionals.