What is a Roth IRA?

June 26, 2024

You've heard the old saying that death and taxes are inevitable. It turns out the taxes part is not always inevitable for one particular investment account: the Roth IRA.

Let's dive in!

What is a Roth IRA?

It's a retirement account that provides tax-free growth and distributions. Unlike a Traditional IRA, the Roth IRA is a post-tax account. This means you are putting in already taxed money, so you don't receive a benefit upfront. In return, the account provides a tax benefit later.

Here are a couple of highlights to know:

→ Tax-Free

As you build wealth inside the account, these earnings are not taxed as they grow. You access the earnings tax-free once you take them out at 59 1/2. It's one of the few vehicles that provides a true tax-free benefit when requirements are met.

→ Limitations

With great tax benefits comes great responsibility... and limits. Let's lay out the big ones:

  • Access: You cannot access your earnings until you are 59 1/2, or else not only could these be taxable, but you would also be hit with a 10% penalty. Some rules that bypass the penalty include:
    • First-time home purchase ($10,000)
    • Education Expenses
    • Disability
    • Death
    • Etc.
  • Income: There are limitations based on your modified adjusted gross income (MAGI) that year. Make over these limits, and you'll be unable to contribute directly to it. However, if you have an issue with this, there is a way to get around it (more on this in the future). You can find the limitations below for 2024 (income within limits are phased out):
    • Single: $146,000-$161,000
    • Married Filing Jointly: $230,000-$240,000
    • Married Filing Separately: $0-$10,000
  • Contribution: As of 2024, it's capped at $7,000 annually, with an additional $1,000 if you are 50+. This limit is shared alongside the Traditional IRA, so they have the same limit equally. For example, if you are under 50 and put $3,000 in a Traditional IRA, you have $4,000 left to put in a Roth IRA. Keep in mind that this is just applied to the actual contribution limit. This is not applied to transfers, rollovers, or conversions. The deadline to contribute is typically April 15th of the following year.

→ Distributions

The account works on a first in, first out (FIFO) basis. In other words, what you put in is the first to come out. The Roth IRA is composed of 3 different sections:

  • Contributions
  • Conversions
  • Earnings

1) The contributions are after-tax funds. These can be taken out anytime, regardless of age or holding period. These are the first to go out.

2) The conversions are created by converting funds from a pre-tax account. Each conversion must be left for at least 5 years until it can be accessed penalty-free. The conversion usually triggers a taxable event. However, if the converted funds have been held for 5 years, distributions from the conversions won't be penalized even if they are taken out before 59 1/2.

3) The earnings are the last to come out and have the strictest limitations. There are exceptions as long as the account has been held for 5 years and used for a qualified purpose to avoid a penalty. However, the earnings may still be taxed as income, depending on the reason. Otherwise, the limitations are typically not a problem once taken out at 59 1/2 years old so long as the account has been held for 5 years.

→ No RMDs

In tax-deferred accounts, there will be a day to pay pre-tax money. However, the government doesn't want this deferred for too long. As a result, the government puts in required minimum distributions (RMD), so retirees have a minimum amount they must distribute to pay taxes. But the money you put in a Roth has already been taxed, and the growth is tax-free. This ultimately means the government has no reason to rush you into taking out tax-free money. Therefore, there is no requirement for minimum distributions (RMD). Note: If you inherit the Roth IRA as a beneficiary, you may be subject to the RMD rules.

Roth IRAs are unique for their tax-free features, but having a game plan behind the scenes is important. Always determine if it's the right fit for your situation. But as you weigh your options, tax-free growth should not be overlooked!

- Max

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