Ready For Retirement
Ready For Retirement
7 Things You Need to Know About Roth IRAs to Maximize Tax-Free Income
Roth IRAs offer great tax-free income benefits, but to make the most of them in retirement, here are seven things you need to know:
- Contribution Limits: In 2024, you can contribute up to $7,000 annually ($8,000 if 50+), across both Roth and traditional IRAs.
- Access to Contributions: You can withdraw your contributions at any time, tax-free and penalty-free. Only earnings are subject to penalties if withdrawn early.
- The Five-Year Rule: To withdraw earnings tax-free, the Roth IRA must be held for at least five years.
- Income Limits & Backdoor Roths: High earners may not be able to contribute directly, but a backdoor Roth strategy can help. Consult a financial advisor for guidance.
- No RMDs: Roth IRAs don’t require minimum distributions, allowing your funds to grow as long as you want.
- No Impact on Social Security: Roth IRA withdrawals won’t count toward your provisional income, potentially lowering your Social Security tax.
- No Medicare Surcharge: Roth withdrawals don’t affect your adjusted gross income, helping you avoid higher Medicare premiums.
By understanding the points above, you can use a Roth IRA to manage taxes and increase flexibility in your retirement.
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Timestamps:
0:00 - What is a Roth IRA?
1:38 - Free withdrawals
3:15 - The 5-year rule
4:49 - Income thresholds
6:01 - Backdoor Roth contribution
8:18 - No RMDs
9:26 - Not provisional income
12:10 - Not part of IRMA calculations
13:06 - Income requirement nuances
14:49 - Wrap-up
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Many of us know the benefits of Roth IRA, at least at a high level. We know that they can create tax-free income of some type. However, to truly utilize Roth IRAs to their fullest extent, it's important that we know all of the different nuances to Roth IRAs so we can most effectively use them in our planning. That's why, today, I'm going to go over seven things you need to know about Roth IRAs to ensure you're getting the most out of them when it comes to your retirement planning. This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. To start, let's define what a Roth IRA is. A Roth IRA is an individual retirement account or individual retirement arrangement and, unlike a traditional IRA, where any money that you put in is considered pre-tax, meaning you get a tax deferral on those contributions, but then when you pull that money out, typically in retirement, you pay taxes on it, it's the complete opposite With a Roth IRA, any contributions that you put in, you don't get any tax break for. However, all of the growth from then on assuming you're making qualified distributions in the future. The growth is both tax-free as well, as the distributions are tax-free as well. So what do you need to know about Roth IRAs? Well, number one, the first thing that you need to know, is how much can you put into it. But that's just the basics. From there, we're going to go over seven other different things you need to know to ensure you're getting the most out of Roth IRAs when it comes to utilizing them effectively in your planning. So for 2024, and these numbers will stay the same for 2025, you can put up to $7,000 per individual into a Roth IRA or traditional IRA. Now that $7,000 limit is cumulative. So, hypothetically, you could put $4,000 into a Roth and $3,000 into an IRA. You could put $7,000 into one and nothing in the other, but that $7,000 is a cap between the two. If you are 50 years old or older, you can make an additional $1,000 catch-up contribution for a total of $8,000. So that's the starting point. That's what most people do know about Roth IRAs.
Speaker 1:Let's start going through, in no particular order, other planning points you need to know about Roth IRAs. The first planning point, number one, is that contributions to Roth IRAs are available for withdrawal at any time. You do not have to be 59 and a half, you don't have to reach a certain age to access your contributions, completely penalty-free and tax-free. So, hypothetically, let's say that you're 35 years old and you make a $5,000 contribution this year and the next year and the following year, and then you don't touch those dollars and they grow to, let's say, $25,000 by the time that you're 40. So by the time that you're 40, you have $25,000 in your Roth IRA. 15 of that is your own contribution and 10,000 of that is growth on your Roth contributions. You can pull out the 15,000 that you put in completely tax-free, completely penalty-free. It does not matter that you're not 59 and a half yet. It's the growth on those dollars that you can't touch until 59 and a half. So if you were to pull out the $10,000 of growth, that is what would be taxed, that is what would be assessed an early withdrawal penalty of 10%. But the contributions themselves can be pulled out at any time.
Speaker 1:Now you may ask well, how does the IRS know if this contribution I'm pulling out is actually money that I put in or if it's growth on that money? The IRS is always going to treat the first dollars out of your Roth IRA as contributions. So hypothetically, to use the same example, if you've put in $15,000 over the course of your lifetime, the first $15,000 that you withdraw, you don't get to tell your Roth IRA provider or the IRS this is growth or this is contribution. The IRS just assumes that the first $15,000 is contribution. Once you've pulled out that amount, then they're going to assume that the difference above that is growth in that example.
Speaker 1:The second thing to know about Roth IRAs is there's something called the five-year rule. Now, the five-year rule says that you need to wait five years from the time that you've opened and funded your original Roth IRA until you can pull money out tax-free. Now, to add on to point number one and point number one, I said you can take contributions out at any time. That is still true. What I'm talking about with the five-year rule is, in order to get access to the growth on those dollars, you need to have waited at least five years. For most people this is somewhat irrelevant, because you open your account and you've typically had it funded for more than five years before you start making withdrawals, especially because for most people, it makes a lot of sense for your Roth IRA to be some of the last dollars that you use in retirement. Although not always Because of that, you're almost always going to be meeting the five-year rule.
Speaker 1:But let's say that you are 58 years old and you open your first Roth IRA. In two years from now you retire. Now you've contributed to your Roth IRA for a couple of years. Let's assume $5,000 per year. So you put in 10,000 and let's assume that 10,000 has grown to 12,000. And you say you know what? I want to take this whole 12,000 out, because I'm now above 59 and a half and this is a Roth IRA. Therefore this money should all be tax-free. Well, not quite, because you haven't met the five-year rule. The $2,000 of growth in this example would still be subject to a penalty because it's not a qualified distribution, because it's not yet met the five-year rule. Now I'm going to include a link to another video that I've made right up here. In that video I break down the five-year rule in much more detail, because there's things that have to do with well, what if it's a conversion? What if it's a contribution? How does this work in different scenarios? So be sure to check that video out, where I go over that in more detail.
Speaker 1:The third thing that you need to know about Roth IRAs is that even if your income is too high, you can still get money into Roth IRAs. So let's back up. What does it mean your income being too high? Well, for 2024, if you're married, finally and jointly, if your income exceeds $240,000, and by income specifically, I mean your modified adjusted gross income. If that exceeds $240,000, no-transcript, from $230,000 to $240,000, there's a phase-out, meaning if you make under $230,000 of modified adjusted gross income and you're married, family and jointly, you can make a full Roth IRA contribution.
Speaker 1:If you make over $240,000, you cannot make any Roth contribution. If you make somewhere in between, you get to make a phased-out contribution depending on your income levels. If you're single, those numbers are $146,000 to $161,000. So under $146,000 of modified adjusted gross income, you can make a full contribution. Over $161,000 of modified adjusted gross income, you can't make any contribution, and anywhere in between, your contribution limit starts being phased out. So what do you do if you make above that amount?
Speaker 1:Typically, you think, okay, I just can't make a Roth contribution. Well, you still can. There's two ways in which you can do so. One is what's called a backdoor Roth contribution. Now, the backdoor Roth contribution. There are a lot of rules around this, specifically something called the pro rata rule. So talk to your financial advisor, talk to your tax preparer before you do this. But if you make, let's say, $300,000 and you're not eligible to make a direct Roth IRA contribution, what you can do is you can contribute to what's called a non-deductible IRA, so AKA just a traditional IRA, but because of your income you're not going to be able to deduct that traditional IRA contribution, assuming you're covered by a retirement plan at work.
Speaker 1:This is where I say there's more details to this I'm going to cover right now. So talk to your financial advisor, talk to your tax advisor before doing anything. But if you make a non-deductible IRA contribution, you can then convert that into your Roth. That's the concept of a backdoor Roth contribution. In addition to that, you can also maybe make a mega backdoor Roth contribution. So if your 401k plan at work allows for after-tax contributions, that can then be converted to Roth contributions. That's another way of doing the same thing. You make an after-tax contribution, aka you don't get a tax benefit for making that contribution. But because you don't get a tax benefit, those aren't pre-tax dollars. So when you convert those dollars to your Roth, there's no tax impact for that converted amount.
Speaker 1:A lot of other details, a lot of other nuances to this. So I'm going to reemphasize this talk to your tax preparer, talk to your financial advisor, do a ton of research before actually implementing this, but that's another great way to get money into a Roth. That being said, 401ks are unique in general in that there are no income limits. So if your plan offers a Roth 401k, it doesn't matter if you make $100,000 or $100 million per year. You can still get the full 401k contribution into a Roth 401k the same way that you could into a traditional 401k. So keep that in mind, that you can always do a Roth 401k regardless of your income, and even if your income exceeds certain limits, you can still potentially do a backdoor Roth contribution. Income exceeds certain limits, you can still potentially do a backdoor Roth contribution. Just be very careful of what's called the pro rata rule, meaning, make sure you don't have other traditional IRAs or simple IRAs or SEP IRAs outside of your 401k, because that could throw a wrench into the whole thing. Or, if your plan allows, you could do a mega backdoor Roth contribution through your 401k at work.
Speaker 1:The fourth thing that you need to know about Roth IRAs is they don't have any required minimum distributions. Now, this can be a huge benefit. If you have a traditional IRA or a traditional 401k. When you turn age 75 or 73, depending upon your birth year you're going to be required to start taking funds out of that account. A general way to think of that is your first year of required distributions. You're going to be forced to distribute about 3.8% of your account balance as a required distribution. As you age, that number goes up. By the time that you're in your mid to late 80s it's closer to 7% to 8% of your entire account balance that you're forced to distribute. Now with a Roth IRA, that's not the case as of now. With a Roth IRA, you can continue letting that thing grow. So if you want to continue letting it grow, aka continue to grow tax-free, compound tax-free, so you have more tax-free income in the future, you can do so. Or if you want this to be an account that you can ultimately pass to your children or your beneficiaries, that's a Roth account that can continue growing tax-free and ultimately pass to the next generation and it can be a substantial asset for them as well. So that's a really important thing. To note is no RMD on Roth IRAs.
Speaker 1:The fifth thing that you need to know is that Roth IRA distributions are not included in provisional income. Now, if you're not collecting social security yet, provisional income does not mean anything to you, but as soon as you start collecting social security, provisional income becomes pretty significant for a good number of people. So what is provisional income becomes pretty significant for a good number of people. So what is provisional income? I'm not going to go over all of it in today's video, but what it is is it's essentially a formula to calculate how much of your social security benefit is going to be pulled into the income that you're being taxed on. Because when you look at your social security benefit at a federal level, anywhere between zero and 85% of that benefit is included in the income that you pay taxes on. So one of the important things to note when you do that is that your social security benefit itself half of that amount is included in your provisional income.
Speaker 1:So let's look at a basic example. If you are married and your provisional income is under $32,000, zero percent of your social security benefit is included in your income that you pay taxes on. If your provisional income is between $32,000 and $44,000, 50% of those dollars are included in what you pay taxes on. Or if your provisional income is above $44,000, then up to 85% is included in the income that you pay taxes on. So let's look at an example, because it can be a little confusing. But let's assume that you're married and both spouses have a social security benefit of $2,500 per month, so 5,000 per month total, which is 60,000 per year, and they're taking a combined 4,000 per month in their Roth IRAs. That's $9,000 per month of income. For a lot of people, that's a pretty healthy level of income until you start to think well, what is that number after taxes? Are we taking out $1,000 for taxes? Are we taking out $2,000 for taxes? Because then that's a different story in terms of how far that $9,000 goes.
Speaker 1:Well, here's the thing. If that was their only income source, we want to start by calculating what is their provisional income. We'll start by taking half of their Social Security benefit. If their total Social Security benefit is $60,000, half is then $30,000. If their only other income source is social security, which is $4,000 per month or $48,000 per year, it doesn't matter how much that is it's not included in their provisional income. So their provisional income is only $30,000, which means they're under the threshold and none of their social security benefit is included in their taxable income, and Roth IRAs aren't taxed as well. So they're taking home $9,000 per month and not paying taxes on any of it. Now, that example is a little bit cherry-picked, because most people have interest from cash in the bank. Maybe they have some dividends, maybe they have other types of income, but you can start to see the power of having a low provisional income in that it protects a lot more of your Social Security benefit from being taxed. So all this to say anything that you do have in Roth IRAs, when you do pull it out, it's not going to impact your provisional income.
Speaker 1:The sixth thing to know about Roth IRA income and this is kind of like a tag along to point number five is that Roth IRA income is not included in your IRMA calculations. So, depending on what your income is, that's going to determine not just what income taxes you pay at the federal level and or state level. It's also going to include things like how much do you pay in Medicare surcharges? This is what IRMA is. Irma is do you have to owe an additional surcharge in addition to your normal Medicare Part B and Part D premiums. Well, that's based upon your modified adjusted gross income, and because your Roth IRA income is not included in your modified adjusted gross income, and because your Roth IRA income is not included in your modified adjusted gross income, you could hypothetically be taking out a million dollars a year from your Roth IRA, and not only would that not be taxable, but it would not drive up your Medicare premiums, your Medicare surcharges, in terms of the premiums that you're paying there. So another benefit with Roth IRAs, not only are they not subject to federal or state taxes, but it can also help you to keep your Medicare premiums low.
Speaker 1:And then, finally, the seventh thing that you need to know about Roth IRAs is that just because you're not working doesn't mean that you can't contribute to a Roth. Roth IRAs are based upon earned income, so if you and a spouse if neither of you are working, you don't have any earned income, neither of you can contribute to a Roth. If one of you is working, though, your eligibility to contribute to a Roth IRA is based upon your income as a couple. So as long as one of you is earning, let's say, $16,000 per year, the both of you could contribute $8,000 each to a Roth IRA, even if that $16,000 is coming from one spouse and the other spouse has nothing. Now you may say well, james, if you're only earning $16,000 per year, you need to live on that. You can't actually use that to contribute to your Roth. That's very true, unless maybe you're earning a low amount because, let's say, you're working part-time. Before you retire, maybe you have a brokerage account and maybe that brokerage account you say let's start sliding some of these assets that we're paying taxes on the dividends and interest and growth. Why don't we slide 8,000 per year of that into our Roth IRAs? And now all the growth on that is completely tax-free forever. So even if you have low income and only one spouse has income, you can still make a spousal IRA contribution as long as there is earned income that justifies both of those contributions.
Speaker 1:Now one final point as we wrap up here this isn't one of the seven, but an important thing to note that a lot of people get confused on is there's income limits for Roth IRA contributions. There are not income limits for Roth IRA conversions. So just because your income is a certain level means you can't make a Roth contribution anymore, but that does not prevent you from doing Roth conversions. So keep that in mind that these income limitations have to do with contributions. They don't have to do with actual conversions. So those are seven things that you need to know If you're going to have a Roth IRA. Know that it can be powerful when it comes to your ability to control your tax situation in retirement.
Speaker 1:But if you don't know all the different nuances and details to Roth IRAs, you're not going to be able to use them as effectively as you otherwise could have Roth IRAs. You're not going to be able to use them as effectively as you otherwise could have. So I hope that's helpful. If you're watching this on YouTube, please make sure that you like you subscribe, make sure that you get notified every time new videos come out. If you're listening on Apple Podcasts or Spotify, please leave a review if you're enjoying the show. And also if you know someone that you think could benefit from this show or is preparing to retire, please be sure to share this with them to make sure that as many people as possible get the information they need as they prepare for retirement. That's it for this episode and I'll see you all next time.
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