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Is a Roth IRA Right for You?

Bryan Strike, MS, MTx, CFA, CFP®, CPA, PFS, CIPM, RICP®

Director, Financial Planning Research & Education

Summary

Roth IRA can be an essential financial planning tool for almost anyone. Here are the rules and guidelines you need to know.

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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.

 

Roth IRA rules

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

  • Contributions are considered to be first-out distributions. A contribution is a return of basis, so it’s tax free and penalty free at any time, for any reason. You can contribute to a Roth IRA one day and remove those funds a day later without any tax ramifications.
  • Conversions are considered to be second-out distributions. A conversion requires the taxpayer to pay tax on the converted amount at the time of distribution. Again, a conversion is a return of basis that is distributed tax free at any time. The catch, however, is that the distribution of a converted amount must meet an exception to the 10% penalty—even though it’s free from tax—or it will be penalized.
  • Exceptions include: being 59½ or older, a first-time home purchase (limited), health insurance premiums when unemployed, death, disability, qualified higher education expenses, otherwise deductible medical expenses, substantially equal periodic payments.
  • There’s also a special exception for converted amounts: meeting the five-year conversion holding period, which means holding the converted amount in a Roth IRA for at least five years from January 1 of the year when the conversion was made. In other words, a second-out distribution will not face the 10% penalty if the Roth IRA has met the five-year conversion holding criteria.
  • Earnings are last out and have three potential taxation results:
  • Earnings are tax free and penalty free if the five-year lifetime holding period has been met and the distribution is due to age (59½ or older), death, disability, or first-time home purchase (limited). The five-year lifetime holding period begins on January 1 of the year when a contribution or conversion was made, and it ends on the last day of the fifth consecutive taxable year.
  • Earnings are taxable but no penalty applies if the lifetime holding period has been met and one of the other exceptions to the 10% penalty applies (health insurance premiums when unemployed, qualified higher education expenses, otherwise deductible medical expenses, substantially equal periodic payments). Similarly, earnings are taxable and no penalty applies if the lifetime holding period has not been met and any exception to the 10% penalty applies.
  • Earnings are taxable and subject to penalty if none of the exceptions applies to the distribution, regardless of whether the lifetime holding period has been met.

Example 1:

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.

Example 2:

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.

  • If Broadrick pulled out $100,000 from the Roth IRA in 2023 to take his family on a six-month cruise around the world, he will not owe any tax but will be charged a 10% penalty on the $100,000.
  • If Broadrick keeps the $500,000 conversion in his Roth IRA until at least 2025, he can access it tax and penalty free.
  • Alternatively, once Broadrick reaches age 59½, he can access the $500,000 tax and penalty free without having to hold it for five years. Same for any of the other exceptions listed above.

Example 3:

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.

 

Why anyone should consider a Roth IRA

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.

 

Inheriting a Roth IRA

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.

Example 4:

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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