One common pain point for almost all clients is taxes. We all recognize there are some benefits to paying taxes…we get roads, bridges, schools, etc. However, while we understand the concept, everyone would prefer we collect taxes from someone else. I have found this to be basically universally true in my practice. Most clients want to save on taxes. Thus, I was surprised in a recent discussion when a client told me they had always heard that the Roth IRA is a bad thing.
The Roth IRA is a tax-advantaged account. It has pros and cons. For some people, it can help them achieve their financial goals, and for others, there are better options. A blanket statement that “Roth IRA’s are bad” is like saying “hammers are bad”. If you are trying to tighten the screws on your doorknob at home, most would agree that a screwdriver is a better tool for the job. However, no one would say that a hammer is simply bad. In investing, we often develop these dogmatic views about something being bad or good. The truth is, there are many account types, investment strategies, and philosophies that when used properly and for the right job, work quite well. So let's try to take an unbiased look at the Roth IRA, and discuss what’s good, what’s bad, and how to use it properly.
What Is It?
IRA, per the IRS code, stands for Individual Retirement Arrangement. We also colloquially refer to them as Individual Retirement Accounts. With this type of account, investors who have earned income, and are below certain income thresholds, contribute after-tax dollars into an account, and purchase investments. So long as certain conditions are met, the growth on these investments never gets taxed. Thus, earnings can become tax-free. In most cases, when you make money, you have to pay taxes, period. This is one of several exceptions in the U.S. tax code that allows you to make money and not pay taxes on your earnings.
What Are the Rules of this Game?
For starters, as we mentioned, you have to have earned income equal to or greater than the amount of money you are contributing. In 2024, the maximum contribution to a Roth IRA for a person under the age of 50 is $7,000. If you are over 50, you may contribute up to $8,000. Thus, if you only made $3,000 in earned income in 2024, the maximum amount of your contribution is $3,000 (everything you made). However, if you made $75,000 in 2024, and you are 38 years old, the most you can contribute is $7,000. What qualifies as earned income is an entire separate discussion, and I recommend you consult a Certified Public Accountant (CPA) when considering what retirement contribution strategy is best for you.
Next, to be eligible to contribute directly to a Roth IRA, you must be below certain income thresholds. For 2024, if you are a single filer, you must make less than $146,000 to make the full contribution. If you are a single filer and make between $146,000 and $161,000, you may still make a partial contribution, but your ability to contribute slowly phases out between these levels of income. If you make more than $161,000, you would not be eligible to contribute directly to a Roth. For married couples filing jointly, this phaseout range is $230,000 to $240,000, meaning at income below $230,000 a full contribution could be made, but between $230,000 and $240,000, you get phased out from eligibility.
Now if you get phased out from being able to contribute, fear not, there is still a way to contribute to a Roth IRA, which is called a Back Door Roth strategy. Simply put, this involves making a non-deductible contribution to a Traditional IRA and then completing a Roth conversion. This strategy goes beyond a basic discussion of the Roth IRA, and we recommend consulting a CPA before completing a Back Door Roth. There are pro-rata rules that require you to aggregate retirement accounts when completing a Roth conversion, and a mistake here could be costly. TALK TO A CPA BEFORE EXECUTING THIS!!!
Contributions to a Roth IRA must be made by April 15 in the year following the tax year you are making the contribution for. Thus, if you are under 50 years old, and want to contribute the full maximum of $7,000 for 2024, you have until April 15, 2025 to do so. As of January 1, 2025, you would be eligible to contribute another $7,000 for 2025, but the caveat is you will have to have $7,000 of earned income in 2025, or else the contribution would become ineligible.
The amount you contribute into your Roth account is referred to as your BASIS. Basis can be removed at any time, tax and penalty free. It makes sense, because you already paid taxes on this money; it’s yours, you can do what you want with it. However, if you invest your contributions in the Roth IRA, the profits are not part of your basis. We call this portion EARNINGS. You need to accomplish two things to distribute earnings from a Roth IRA tax and penalty free, which is called a qualified distribution. You have to be 59.5 years old. Your Roth IRA had to have been opened for over 5 years. You have to do both. If you have not done both, the earnings will be taxed. If you are below 59.5, you will also pay a 10% penalty on the distribution. It is critical if you intend to invest in a Roth IRA, that either you understand basis and earnings, or you hire someone to keep track of this for you. A Certified Financial Planner (CFP®) regularly helps clients with this.
Who Can This Work Well For?
Well first off, if you are not currently saving in a retirement account, and you meet the income criteria to contribute to a Roth IRA, it could qualify you for the Saver's Credit. The Saver’s Credit is a tax credit designed to encourage people with low to middle income to save for retirement. The credit is worth up to $1,000 per individual (must be 18 years old and not claimed as a dependent on someone else’s taxes), and $2,000 per married couple. Remember, tax credits are dollar for dollar reductions in our tax liability, as opposed to tax deductions, which reduce taxable income. Tax credits are very powerful tax planning tools, and we want to use every one that we qualify for. Yet another reason to hire a good CPA, they can often pay for themselves with just a small recommendation.
Broadly speaking, the Roth IRA as a planning tool works well if you believe that your taxes will be higher in the future than they are today. Now this part is complicated, because there are multiple things that could cause this, and it’s hard to predict. Tax rates are currently historically low, and could rise in the future. However, none of us know how much. Additionally, if you will have a good pension and social security payment, and have done a good job saving for retirement, you will likely be forced to take required minimum distributions from pre-tax retirement accounts like 401(k)’s, traditional IRA’s, and the like. All of these could push you into a higher tax bracket in retirement, so having an account that is not subject to RMDs, where distributions are not taxed, can be a huge help.
The ultimate decision of whether or not a Roth could work well for your individual situation is a very complex combination of mathematics, combined with some assumptions about complicated tax law. Financial planners utilize advanced software to model out multiple scenarios and give specific advice on this topic. Thus, hiring a CFP® makes a lot of sense if you are thinking seriously about your retirement.
Another situation where I have seen Roth IRA’s be beneficial is for families that do not have sufficient emergency funds, but also need to start saving for retirement. Using the Roth as a combination retirement account/emergency savings vehicle can be a powerful tool to kickstart your path to financial security. You can contribute aggressively knowing that if push came to shove, you could withdraw your basis to cover emergency expenses. If this is your strategy, your asset allocation inside the Roth (what you invest in) should reflect this. Money you could need in the next five years goes in fixed income investments, money you don’t need for 5+ years can be invested in equities.) The benefit here is that even if you do need to remove some basis from time to time, earnings can continue to grow. This lets you get the most out of compound interest, even if life throws you an unexpected curve ball.
Who Does This Not Work Well For?
To put this simply, basically the inverse of who it works well for. If you expect that your income will be significantly less in the future than it is now, pre-tax retirement accounts like 401(k), 403(b), Traditional IRA, etc. will likely be better options. These pre-tax accounts offer deductions above the line (also referred to as for AGI). These deductions can be very valuable for high earners who can take them. Especially for high earners who earn their money via W-2 income, these ATL deductions are essentially some of the best planning opportunities they have.
Pre-tax being a better option is especially true for higher earning, high spending families. If spending is high, typically savings is low, and thus getting a tax deduction now during high earnings years is beneficial. The thinking here is that if you aren’t saving much, your income in retirement will likely be much lower, so you can pay taxes on the distributions at a lower marginal tax rate.
Another situation where a Roth IRA might not be an optimal choice is for families who make too much to contribute directly to a Roth IRA, and would consider using the Back Door strategy, but who have significant traditional IRA balances. Due to the pro-rata IRA rules, a person has to aggregate all IRA accounts when making a Roth conversion (a necessary step to completing the Backdoor Roth). A typical Backdoor Roth would push a non-deductible contribution from a Traditional IRA into a Roth. However, if you have a big balance in an existing Traditional IRA, any conversions to Roth would be considered pro-rata, which means the amount being converted is said to have come proportionally from the non-deductible portion, and the deductible portion. The deductible portion would have come from the existing traditional IRA. That amount will get taxed. Thus, it seems like you are making contributions with taxed money, and getting taxed again on the conversion. Not ideal, especially if you are already high income.
The Verdict
As you can see, there are a multitude of factors to consider when deciding which retirement savings vehicle is best for you. The U.S. tax code is thousands of pages long, and changes all the time. By partnering with professionals whose job is literally to study these changes, the impact to their clients, and how to maximize after-tax wealth, you could improve your ability to achieve financial independence and reach your personal financial goals. There are different strategies that work well in different situations, and hiring a good CPA and financial planner is like hiring a professional construction crew to remodel your home. You could probably do it yourself, but by the time you pay to fix all your mistakes, you might have been better off just hiring the professionals.