Roth IRA can be an essential financial planning tool for almost anyone. Here are the rules and guidelines you need to know.
Roth IRA became a retirement savings option in 1998, creating a means for potentially tax-free retirement income. Not only can you contribute directly to a Roth IRA, but you can also convert funds from a traditional IRA or employer-sponsored plan. Conversions were originally limited, based on a taxpayer’s adjusted gross income (AGI), but that changed in 2010, unleashing an extremely popular strategy for early retirement.
The rules for a Roth IRA seem simple, at least on the surface. Unlike a traditional IRA, contributions to a Roth IRA are not tax-deductible. Also, a taxpayer’s AGI must be below a certain threshold if they want to contribute to a Roth IRA. The threshold in 2024 is $161,000 single filers, and $240,000 for those who are married and filing jointly. As far as contributions go, there are limits. For 2024, you can contribute $7,000 if you’re younger than 50, and $8,000 if you’re 50 or older. Growth is tax-deferred, so interest, dividends, and capital gains are not taxable. Distributions in retirement are generally tax free.1 The keyword is “generally.”
Distributions from a Roth IRA are ordered in a specific way, and the order is typically beneficial to the taxpayer.2
Samantha contributed $6,500 to her Roth IRA in 2023. She can distribute $6,500 at any time for any reason, tax and penalty free.
Broadrick retired, opened a Roth IRA in September 2020, and converted $500,000 from his 401(k) to the Roth IRA. He owed tax on the $500,000 in 2020 when the conversion was made, but there was no penalty at that time. Broadrick can access the $500,000 tax free at any time after the conversion but may owe a penalty.
Amber contributed $5,000 to her Roth IRA for tax-year 2022 on February 8, 2023. Her five-year lifetime holding period began on January 1, 2022, and ends on December 31, 2026. If her account grows to $7,000 and she fully liquidates it prior to 2027, the $2,000 in earnings will be taxable and possibly subject to a 10% penalty. If she waits until 2027 or later and is 59½ or older, the $2,000 in earnings will be tax and penalty free.
Let’s start with the “how”: Opening a Roth IRA is very easy and requires only a minimal deposit. The deposit can be a contribution, if you earned income that year and your total AGI is below the threshold. If you can’t contribute, you could convert an amount from a traditional IRA or 401(k) to establish the Roth IRA. The conversion will create taxable income, but the tax will be negligible if the conversion is small.
The “why” entails the five-year lifetime holding period. The only way to distribute earnings from a Roth IRA tax free and penalty free is to meet the holding period criteria, and you must satisfy it only once in your life. Because the five-year rule is applied only once, it can be advantageous to open a Roth IRA early in life (for you, your kids, or your grandkids), even if you don’t expect to make substantial contributions until well into the future.
If you never before expected to own a Roth IRA, why bother now? One reason is that the government has been creating greater access to Roth-style savings accounts. The Roth IRA arrived in 1998, and the Roth 401(k), 403(b), and 457 plans were enacted in 2006. The SECURE 2.0 Act, which was passed at the end of 2022, allows contributions to a Roth SEP-IRA and SIMPLE IRA, along with elections for employer contributions in all plans to be made in a Roth-style manner. High-wage earners age 50 and older are required to make any catch-up contribution to the Roth side of their employer plan. In short, most people who are still in the workforce will likely have some type of Roth account in the future.
Unfortunately, the rule about the five-year lifetime holding period doesn’t cross between Roth-style employer plans and Roth IRAs.3 For example, if you meet the five-year period for a Roth 401(k) and roll over the funds to your first Roth IRA at retirement, the Roth IRA will still need to have been held five years before a qualified distribution can be made. If you’ve already met the five-year lifetime holding period for the Roth IRA, then you may begin qualified distributions immediately after the rollover.
What if you inherit a Roth IRA? The good news is that a decedent’s five-year lifetime holding period carries over to their beneficiary.4 If you inherit a Roth IRA from someone who had already met the holding period, distributions from that beneficiary Roth IRA will be qualified. It’s important to note that the decedent’s holding period carries over with their Roth IRA only—not to the beneficiary’s own Roth IRA.
Zach opened a Roth IRA in 2020. His mother died in 2022, leaving him with her Roth IRA, which she’d held for more than five years. Distributions from the inherited Roth IRA are qualified, but distributions from Zach’s own Roth IRA won’t be qualified until 2025, unless he reaches age 59½, dies, is disabled, or uses the funds for a first-time home purchase. The rules for a Roth IRA are more complicated than they appear at first. But it’s simple and relatively inexpensive to open an account and satisfy criteria for the lifetime holding period, thereby removing one roadblock to qualified distributions that are tax and penalty free. If a Roth IRA benefit seems to apply to your situation, discuss retirement planning with your wealth advisor and find out how to get started.
1 Internal Revenue Code §408A
2 Treasury Regulation §1.408A-6, Q&A 8
3 Treasury Regulation §1.408A-10, Q&A 4
4 Treasury Regulation §1.408A-6, Q&A 7
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