A Brief Guide to Roth IRAs

A Brief Guide to Roth IRAs

Individual Retirement Accounts (IRAs) are popular and there are multiple varieties: traditional, rollover, inherited, to name a few. Today I focus on the Roth IRA, which is unique in how it grows tax-free. As we age and move into retirement, distributions that affect income taxes can be a concern. Traditional IRAs and 401ks require you to distribute a taxable amount each year in retirement, which adds directly to your income tax liability. The higher your income tax liability, the more likely that your Social Security will be taxed and your Medicare Part B premium will be increased. Unlike traditional IRAs, withdrawals from Roth IRAs are tax free and thus don’t impact Social Security or Medicare premiums.

There are whole books written on Roth IRAs and the strategies associated therewith. My goal below is to just give you some basic facts that may intrigue you to ask more questions:

1. Unlike traditional IRAs that are funded with pre-tax amounts, Roth IRAs are funded with after-tax amounts and thereafter allowed to grow tax-free. Pay the tax now and fund a Roth IRA vs. delay the tax until later and fund a traditional IRA.
2. Unlike traditional IRAs, there are no required minimum distributions from Roth IRAs for the original owner. Beneficial owners after the death of the original owner do have a 10-year time limit to fully withdraw the funds from the Roth IRA but there’s no tax associated with the withdrawal.
3. There are contribution limits to a Roth IRA. First, you can only contribute an amount equal to or less than your earned income for the year. For 2025 the contribution limit is $7,000 if you’re under 50 and $8,000 if you’re over 50. There’s also a phaseout on your ability to contribute that begins at $150,000 for single filers and $236,000 for married couples filing jointly. For high earners there still may be ways to get around the income limits (see paragraph 5 below).
4. Employer Roth IRAs through a 401(k) plan are becoming more popular. If your employer offers one, the 2025 total employee and employer contribution limit is $70,000 and the employee portion is based on age: $23,500 if under 50, $31,000 if 50 or older, and (just to make things more complicated) there is also a “super” catch up rule for those age 60 to 63 that allows for a $34,250 employee contribution. All those limits are subject to the company 401k plan rules.
5. Outside of a traditional Roth or a 401(k) Roth, there is also the area of Roth conversions. Basically, it’s a process in which you take money that you contributed pre-tax to a traditional IRA and “convert” it to a Roth IRA after paying taxes on the amount converted. Subsets of the Roth IRA conversion have fancy names like the “Back Door Roth Conversion” and the “Mega Back Door Roth Conversion.” The concept is similar in that you are putting money into a traditional IRA or 401(k) and then converting it to a Roth. High earners can use these “back door” approaches to get around contribution limits.  There are several factors to consider in deciding if a Roth conversion is right for you. They include relative marginal income tax rates now and in the future, whether you are in your highest income earning years, and the amount you currently have in tax-deferred traditional IRAs. Since you must pay taxes on the conversion, the source of outside funds available to pay the taxes is also a factor. Note though you cannot make a Roth conversion with an IRA you inherited from someone else. It has to be your original traditional IRA.
6. There are limits to withdrawals from Roth IRAs and their complexity is beyond this weekly newsletter. Many people who look into Roths come across the five-year rule that says you will be penalized if you withdraw funds from the Roth IRA within five years of its creation. That rule is commonly misunderstood. The rule only applies to the growth in the Roth IRA. Your original contribution amount can be withdrawn at any time without a penalty or a tax. Note there are different rules for withdrawals from 401(k) Roths that aren’t so accommodating.

Roth IRAs have their place in an investment portfolio because of their tax-free nature and avoidance of required minimum distributions. However, there are many factors to weigh before determining if a Roth is right for you. The younger you are, the better the Roth option becomes. If you have a friend or loved one in their teens who has a basic job, a wonderful gift is to open a Roth IRA and contribute an amount that equals their wages for the year. Just think of the growth over decades tax-free.

Fun fact: I hope you’ve been following my beloved Pistons basketball team. They are in a playoff dogfight with the New York Knicks and growing into seasoned competitors. The Pistons have won 3 world championships: 1989, 1990 and 2004. They are slowly getting closer to their 4^th!