Everything You Need to Know About Roth IRAs

There’s one catch. How much you can contribute to a Roth IRA may be reduced or phased out to zero dollars, depending on your modified adjusted gross income, or MAGI in IRS parlance. MAGI is your adjusted gross income on your 1040 or 1040-SR tax form, minus certain deductions, such as student loan interest.

In general, married couples filing jointly can contribute the Roth IRA maximum in 2023 if their MAGI is less than $218,000, and they can contribute the full amount in 2024 if they earn less than $230,000. Higher earners will be able to contribute either a reduced amount or nothing at all. The MAGI cutoff to contribute the maximum to a Roth IRA if you are single, head of household or married filing separately in 2023 is $138,000 and rises to $146,000 for the 2024 tax year.

Withdrawals

You have to be older than 59½ and have held your account for at least five years before you can take tax-free and penalty-free withdrawals. These are called qualified withdrawals. However, you can withdraw your principal at any time, since you’ve already paid taxes on it.

The penalty for not meeting the age and holding period is 10 percent of the amount you withdraw. When you take an early distribution (or haven’t met the five-year test), you’ll owe taxes on your earnings. The IRS figures that you’re taking out your principal first, which is tax-free. If you withdraw all your principal, any earnings withdrawn early will be subject to ordinary income taxes.

You can take penalty-free (but not tax-free) withdrawals from your Roth if you’ve had it less than five years under certain conditions:

• You’re using up to a $10,000 lifetime maximum for the first-time purchase of a home.
• You’re using the withdrawal for qualified education purposes.
• You’re using the withdrawal for qualified expenses related to a birth or adoption.
• You become disabled or die.
• You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.
• You will still owe taxes on the earnings you withdraw.

Happy heirs

The dual advantages of tax-free withdrawals and no RMDs benefit retirees in additional ways. These perks make it easier and more tax-efficient to leave money to heirs, in addition to providing flexibility when making cash-flow decisions in retirement, personal finance pros say.

“Roth IRAs are a great wealth transfer vehicle for people who are already retired,” Reese said. “In fact, they enable you to transfer wealth tax-free.”

Let’s say you have just one granddaughter in her late 30s with a good-paying job. She has a high tax bracket. You want to leave your Roth IRA to her. Using the above example, say that you had a $100,000 Roth IRA account balance that grew to $250,000 or $675,000 in the 10 to 20 years since you retired. That Roth IRA balance can eventually be transferred to your granddaughter, who will also benefit from tax-free withdrawals, as long as you opened the account five years before your death, Reese said.

Inherited Roth IRAs may have RMDs, depending on whether the beneficiary is a spouse or not. Consult a tax expert if you inherit a Roth IRA.  

“The beauty of the Roth IRA is if Grandpa has money in a Roth and continues to save and invest, when the money is handed over to the grandchild, the inheritor can take the money as their own, and any withdrawals are totally tax-free,” Reese said. “The wealth transfer happens without the IRS getting their hands on the money.”

Cash-flow options

Having a tax-free source of income, such as the Roth IRA, also provides cash-flow options. Though retirees can start taking Social Security as early as age 62 (albeit with reduced benefits), your monthly payout will be significantly higher if you delay taking benefits until after your full retirement age (FRA). The IRS will boost your monthly payout by 8 percent every year you hold off taking Social Security beyond your FRA, up until age 70.

Where does the Roth IRA come in? If you can take tax-free withdrawals from your Roth IRA, you can push out the date you start taking Social Security and take advantage of the 8 percent annual boost to your monthly Social Security check.

There’s no other investment that “guarantees an 8 percent return like delaying Social Security does,” Reese said. What’s more, by taking income from your Roth IRA to meet your cash needs, you won’t inadvertently put yourself in a higher tax bracket, as you might if you pulled cash from a traditional IRA or 401(k), which are taxed at normal income rates, Reese said. “The Roth IRA is a great way to bridge the income gap from the day you retire until the day you take Social Security,” he said.

If you hold a traditional IRA, converting to a Roth IRA might make financial sense. While the stock market is still below its all-time highs and bond markets are depressed, the value of your IRA is likely lower than it was at the start of 2022. That means there will probably be a smaller gain, therefore a smaller tax hit when you do the Roth conversion.

Generally speaking, the best time to do a Roth IRA conversion is when you have “a dip” in your taxable income or your taxable income is negative for some reason, said Kelly Wright, director of financial planning at Verdence Capital Advisors. So-called low tax years can occur when, for example, you are well into retirement and your income is lower, or you have a massive medical deduction for dental work or some type of huge loss on your books.

If you have any of those factors working in your favor, “you’re better off doing a Roth conversion now and paying little or no taxes,” Wright said. And you’ll get tax-free withdrawals in the future.