What is a Roth IRA and how does it work?

In a nutshell

There are two types of IRA accounts: Traditional and Roth.

• Traditional IRAs are generally funded with pre-tax contributions, though after-tax contributions are allowed. Withdrawals, except those tied to after-tax contributions, are taxable.
• Roth IRA contributions are made on an after-tax basis. Withdrawals are tax-free if certain requirements are met.

What is a Roth IRA?

A Roth IRA allows for tax-free growth of your investments while held inside of the account and tax-free withdrawals if certain conditions are met. Unlike with a traditional IRA, there is no upfront tax break on the money contributed.

Roth IRAs came about as part of the Taxpayer Relief Act of 1997. Roth accounts are named after Senator William Roth from Delaware, the bill’s chief legislative sponsor.

How a Roth IRA works

Contributions to a Roth IRA are made on an after-tax basis. There is no upfront tax benefit from contributions. However, assuming certain conditions are met, withdrawals from the account will be fully tax and penalty-free. A Roth IRA offers the opportunity for tax diversification among your retirement accounts and other planning options in retirement.

Besides direct contributions to the account, a Roth IRA can be funded from several other sources:

• Rollovers from a 401(k) or similar workplace retirement plan.
• Spousal Roth IRA contributions
• Roth IRA conversions

Roth IRA contribution rules

Contributions to a Roth IRA cannot exceed the annual limits for IRA accounts. For 2024 these contribution limits are $7,000 plus an additional $1,000 in catch-up contributions for those who are 50 or over at any point during the year. These contribution limits are in total for all IRA accounts, both Roth and traditional.

For those who wish to contribute a higher amount to a Roth account, they should look into whether their employer’s retirement plan, such as a 401(k) or 403(b), offers a Roth option. If so, the annual contribution limits would be higher and in line with those for a 401(k) or similar plan. Those contribution limits for 2024 are $23,000, with an additional $7,500 catch-up contribution for those who are 50 or over.

Though not a contribution, Roth conversions offer a method for you to direct funds to a Roth IRA if you are not eligible to contribute or if you want to funnel additional money into a Roth IRA. Note there has been talk of legislation that would potentially abolish the ability to do Roth IRA conversions as well as backdoor and mega-backdoor Roth conversions (discussed below). This legislation has not passed Congress but could be brought up again in the future.

Roth IRA conversions

Money held in a traditional IRA can be converted to a Roth IRA. There are no limits on the amount that can be converted during the year, nor are there any income limitations. Often the easiest way to do a Roth IRA conversion is to convert funds in a traditional IRA to a Roth IRA at the same custodian.

Roth IRA conversions can be done between accounts at different custodians as well, though this can be slightly more complex. Another way to do a Roth IRA conversion is when rolling money from a traditional 401(k) when leaving your employer. This money can be converted to a Roth IRA, all or in part. You will want to coordinate with the custodian to whom you are sending the rollover to ensure that all proper steps are followed.

Roth IRA conversions can be done by transferring cash from the traditional IRA to the Roth IRA or by transferring assets in-kind. This means that securities like stocks, ETFs or mutual funds would be transferred to the Roth IRA account as all or part of the assets to be converted.

Money converted from a traditional retirement account to a Roth IRA is subject to income taxes at the account holder’s ordinary income tax rate. The exception to this is any portion of the converted amount that pertains to after-tax contributions based on the IRS pro-rata rule.

This rule says that the amount of the converted assets will be taxed based on the ratio of money in traditional IRAs that is tied to pre-tax contributions and earnings in the account compared to any assets that represent after-tax contributions.

While Roth IRA conversions are taxed, they can be a powerful planning tool as well. Money that is converted will not be subject to future required minimum distributions (RMDs) and will be eligible for tax-free withdrawals once the five-year rule and other conditions are met. It can make sense to do a Roth IRA conversion in years where your income might be lower than normal or, in some cases, in the years between when you retire and when you claim your Social Security benefits.

Backdoor Roth

A backdoor Roth is a way for those whose income is too high to fund a Roth IRA.

The typical backdoor Roth involves contributing money to a traditional IRA on an after-tax basis and then converting these funds to a Roth IRA account. Whether or not any of the money converted is taxed depends on whether the account holder has other money in a traditional IRA. If they do, the pro-rata rule applies.

Mega-backdoor Roth

This is an option offered by some employers in connection with their 401(k) plan. This option allows employees to contribute up to $46,000 for 2024 on an after-tax basis to a mega backdoor Roth. The annual limit will vary based on any changes made to overall 401(k) limits on the combined amount of employee and employer contributions. Depending upon the plan and their rules, you can convert this money to a Roth in one of several ways.

• If allowed, you can do an in-service withdrawal and roll this money over to a Roth IRA plan at an outside custodian. In some cases, in-service withdrawals, if allowed at all, are subject to age restrictions like age 55 or 59 ½ or older.
• Conversion to a Roth 401(k) option in the plan if the plan offers this option.
• Conversion to a Roth IRA once you leave this employer.

Since this is after-tax money, the only taxes will be on any earnings that have accumulated in the account over time.

In the case where you convert the money to a Roth 401(k) option in the plan, you would do a rollover to a Roth IRA once you leave this employer.

Eligibility and qualifiers

In order to contribute to any type of IRA, whether Roth or traditional, you must have earned income from employment or self-employment. The exception to this is a spousal IRA that is available to a non-working spouse under certain conditions. If your earned income is lower than the annual IRA contribution limits, your contribution cannot exceed the amount of your earned income.

In the case of a Roth IRA, there are income limits that determine whether or not you are eligible to contribute to a Roth IRA in a given year. These income limits are based on your modified adjusted gross income (MAGI) and your tax filing status.

For 2024, the income limits for contributing to a Roth IRA are as follows.

Advantages and benefits of Roth IRAs

Roth IRAs offer a number of advantages and benefits.

No Required minimum distributions (RMDs)

Roth IRAs are not subject to required minimum distributions (RMDs). This is in contrast to traditional IRAs, for which this is required at age 72.

The advantage is that Roth IRA account holders do not need to withdraw money from the Roth account if they don’t need it. This allows them to leave their money in the Roth IRA to continue growing tax-free until they need it.

The exemption from RMDs also lets the money in the Roth IRA accumulate for the account holder’s heirs if desired.

No taxes on inherited Roth IRAs

The SECURE Act legislation that went into effect on January 1, 2020, changed the landscape on inherited IRAs for most non-spousal beneficiaries. The SECURE Act eliminated the “stretch IRA” for most inherited IRAs that allowed beneficiaries to withdraw money based on their life expectancy. As of 2020, the balance of an inherited IRA must be withdrawn within a ten-year period. In the case of a traditional IRA, taxes must be paid.

As long as the account holder has satisfied the five-year rule on the Roth IRA before their death, the inherited Roth IRA passes tax-free to the account beneficiaries. Even though they must withdraw the balance of the inherited Roth IRA within the same 10-year period, these withdrawals are tax-free.

Withdrawal flexibility

The money you’ve contributed to the account can always be withdrawn if needed tax and penalty-free. Earnings from the account could be subject to taxes and penalties if the criterion for a qualified withdrawal is not met.

While withdrawing your contributions is generally not advised, it's nice to know that you have this flexibility.

Tax diversification in retirement

With the ability to withdraw money tax-free from a Roth IRA, these accounts offer tax diversification in retirement for those who hold a significant portion of their retirement savings in traditional IRAs, 401(k)s, or similar retirement accounts.

We don’t know the direction of future tax rates, so having this type of tax diversification with a Roth IRA allows the account holder additional planning options in formulating a retirement withdrawal strategy.

Withdrawals (qualified and non-qualified distributions)

Withdrawals from a Roth IRA are either qualified or non-qualified distributions.

Qualified distributions

Withdrawals of the amount of your own contributions can be taken at any time with no taxes or penalties. However, any withdrawal of earnings that have accumulated inside of the Roth IRA must meet certain conditions in order to be considered as a qualified distribution. Qualified distributions are tax-free and penalty-free.

In order to be considered as a qualified distribution, the withdrawal must have satisfied the five-year rule and meet at least one of the following criteria:

• You are at least 59 ½ at the time of the withdrawal.
• Purchasing, building, or rebuilding a first home for the account holder or qualified family members. Qualified family members include the account holder’s spouse, their children and grandchildren. Other relatives or family members might qualify as well. There is a $10,000 lifetime limit on a distribution for this purpose.
• The account holder becomes disabled, and the distribution occurs after the onset of this disability.
• The distribution is made to the account holder’s beneficiary after the account holder’s death.

The five-year rule

A key factor in determining whether or not a Roth IRA distribution is qualified, as well as issues like the taxation of inherited Roth IRAs, is the five-year rule. There are several components to this rule.

Qualified withdrawals can be made from a Roth IRA after five years from the initial contribution to any Roth IRA account. The five-year clock starts at the beginning of the tax year in which the initial Roth IRA contribution was made.

There is a separate five-year rule for Roth IRA conversions. Each conversion has its own five-year window that needs to be taken into account when taking distributions from a Roth IRA.

Non-qualified distributions

If a distribution is made and does not meet the criteria for a qualified distribution, the amount of the distribution that is comprised of earnings from the account could be subject to taxes and, in some cases, a 10% penalty.

If you are under age 59 ½ and have not met the five-year threshold, then the distribution will be subject to both income taxes and penalties to the extent the distribution includes earnings from the account. You may be able to avoid the 10% penalty (but not the income taxes) in certain cases:

• The distributions are part of a series of substantially equal periodic payments (SEPPS) as defined by the IRS.
• You have unreimbursed medical expenses in excess of 10% of your adjusted gross income.
• The distributions are used to cover your medical insurance premiums after a job loss.
• For qualified higher educational expenses of the account owner or their dependents. This includes related expenses like tuition, books, supplies and equipment. The money must be used in the year the distribution occurs.
• Expenses up to $5,000 to cover the cost of childbirth or adoption within one year of the distribution.
• To cover an IRS levy.
• A qualified reservist distribution while the account owner is called to active military duty.
• A distribution to cover damage from a natural disaster.

All other non-qualified distributions will be subject to both income taxes and a 10% penalty.

How to open a Roth IRA

Your Roth IRA must be opened at a financial institution that is approved by the IRS to offer IRAs. This will generally include banks, brokerage firms, federally insured credit unions, and savings and loans. Major brokers include Charles Schwab, Fidelity Investments, Merrill Lynch, and Vanguard, among others. Many online brokerage sites and apps offer Roth IRAs as well.

You can open a Roth IRA account at any time. Contributions must be made by the tax filing deadline, excluding any extensions, in order to count for a given tax year. Generally, this is April 15 of the following calendar year, this can vary by a day or two if the deadline falls on a weekend or a federal holiday.

Roth IRA versus traditional IRA

There are a number of differences between a Roth IRA and a traditional IRA.

Taxes

Taxes are the biggest difference between a Roth and a traditional IRA. On the front end, contributions to a Roth IRA are always made on an after-tax basis. Contributions to a traditional IRA are made with either pre-tax or after-tax contributions.

Taxation of withdrawals is also different. If certain conditions are met, distributions from a Roth IRA can be withdrawn tax-free. Distributions from a traditional IRA are subject to taxes at the account holder’s ordinary income tax rate, with the exception of the value of any after-tax contributions.

Required minimum distributions

As discussed above, Roth IRAs are not subject to required minimum distributions, traditional IRAs are. This allows account holders to avoid taxes on these RMDs and offers additional flexibility for estate planning purposes.

Contribution income limits

There are income limits above which contributions to a Roth IRA are either limited or completely prohibited. There are no income limits as such for a traditional IRA. However, there are income limitations on the ability to make pre-tax contributions to a traditional IRA if you or a spouse are covered by a retirement plan like a 401(k) at work. Even if you exceed these income limits, there are no income limits for after-tax contributions to a traditional IRA.