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“I love the Roth IRA. Tax-free income in retirement is a truly great deal.” -Suze Orman
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In a recent blog, I discussed the relative merits of a Roth IRA. Many factors determine whether or not Roth IRA contributions make sense. The account holder’s age, tax bracket, net worth, risk tolerance, and available cash are important in establishing a Roth IRA.
One of the most important factors to consider is age. As someone ages, it becomes less advantageous to contribute to a Roth IRA. There is a crossover point where the disadvantage of initially paying taxes outweighs the advantage of tax-free growth.
Unfortunately, there is not one fixed age that is appropriate for every person. Someone who completes a Roth conversion at age 70 and lives to 100 would benefit from thirty years of tax-free growth. A different person who completes a Roth conversion at age 70 and lives to age 73 would have unnecessarily paid taxes while not significantly benefiting from tax-free growth.
In this blog, we’ll assume that someone has decided to invest in a Roth IRA and we’ll move directly to investing at different ages.
Roth IRA accounts can be one of a worker’s most powerful investing tools. Some basic guidelines are important to understand.
To contribute to a Roth IRA, a person must have earned income, such as wages, salary, tips, or self-employment income. Roth IRAs are designed to help individuals save for retirement from their earnings. Passive income streams such as investment income and real estate income are not considered earned income. Because they are not earned income, they do not qualify under Roth IRA investment rules.
It’s also important to understand that Roth IRA Accounts should be opened as early as possible. This helps to satisfy 1/2 of the golden rule for Roth IRAs.
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What is the Golden Rule for Roth IRAs?
The golden rule of Roth IRAs is: “If you’ve had your Roth IRA for at least five years and are at least 59 1/2 years old, you can withdraw your investment earnings tax-free and penalty-free.” This means the age and the holding period requirements must be met for tax-advantaged withdrawals of earnings from a Roth IRA.
Here’s a breakdown:
- Age 59 1/2:This is the general age at which retirement account holders can begin taking withdrawals without penalty.
- Five-Year Rule: This rule applies to withdrawals of investment earnings (not contributions). You must have held the Roth IRA for at least five years from the beginning of the tax year in which you first contributed to any Roth IRA, not just the specific account you’re withdrawing from.
- Tax-Free and Penalty-Free: If the age requirement and five-year rule are met, earnings can be withdrawn without paying taxes or penalties.
Important Considerations:
- Contributions: Withdrawals of your original contributions to a Roth IRA are always tax and penalty-free, regardless of age or how long you’ve held the account, according to Investopedia.
- Conversions: If you convert a traditional IRA to a Roth IRA, the five-year rule applies to the converted funds as well.
- Exceptions: Some exceptions to the five-year rule, such as for first-time home purchases (up to $10,000), disability, or death of the original owner modify holding period requirements.
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Roth IRAs and Age
Young Workers–
Contributing to a Roth IRA makes the most sense when workers are younger. Roth contributions have the greatest growth and compounding over longer periods. The earlier the Roth IRA contribution is made, the more time it has to grow and compound.
There is some irony here because the youngest workers normally have the least discretionary income. Salaries are usually lowest and living expenses are highest for younger workers.
Because Roth contributions are made with earned income, these young workers must give up a significant portion of their wages to contribute to a Roth IRA while paying taxes on the contributed amount. This comes at a time when their disposable income is lowest.
So, the best time strategically is also the worst time financially to make Roth IRA contributions.
There are a couple of side notes that may ease the pain of younger workers. The first is that employers can match Roth 401(k) contributions in the same manner as traditional 401(k) contributions. This is free money for the employee added to a worker’s 401(k) plan by the employer.
The SECURE 2.0 ACT passed in December 2022 allows employers the choice to make matching contributions directly to the employee’s Roth 401(k). According to Investopedia, when an employer matches a Roth 401(k) contribution, it’s still treated as taxable income for the employee in the year the contribution is made. That means the employee will owe income tax on the matching amount.
The second way to ease the pain for younger workers is through legacy giving. I spoke about this strategy in the blog titled GIFTING TO GRANDCHILDREN. Parents and grandparents who pay for Roth IRA contributions (and possibly associated taxes) provide a tremendous gift to their children or grandchildren, while hopefully helping to prevent their gift from being misused or misspent.
Yes, it’s possible that the account holder could remove these contributions without taxes or penalty. It is still a much more elegant strategy than gifting money directly to children and grandchildren.
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Mid-Career-
Workers in the middle of their careers are ideally positioned to make Roth contributions, Roth conversions, or backdoor Roth conversions. The bad news is that their higher mid-career income means they normally pay more taxes on the converted funds.
Roth contributions become easier because higher income means more available dollars to make Roth contributions and pay the associated taxes. You can generally make a full contribution in 2025 if your modified adjusted gross income (MAGI) is below certain thresholds:
- Single filers: Less than $150,000
- Married couples filing jointly: Less than $236,000
- Reduced contributions: If your MAGI falls within a certain range above these limits, you may still be able to make partial contributions.
For example, the phase-out range for single filers is between $150,000 and $165,000, meaning contributions are gradually reduced as income rises within that range. Similarly, for married couples filing jointly, the phase-out range is between $236,000 and $246,000.
Mid-career is an excellent time to begin Roth conversions. I began Roth conversions while actively practicing dentistry and my income was still substantial. I did smaller annual conversions over several years to lessen the tax impact.
In retrospect, this was a good strategy, as it opened the door to larger Roth conversions when I quit working full-time. Yes, you will need to pay more taxes! Over the years I’ve heard from tax professionals and advisors that someone should not let the “tax” tail wag the dog. Don’t forgo a worthwhile strategy because of potential tax implications. While Roth IRA contributions are subject to income limitations, the potential to do Roth conversions is unlimited. Taxpayers can complete a partial or total conversion of a Roth IRA account in any given year. These conversions should be done under the guidance of a CPA or tax professional to gain maximum tax benefit.
Workers who don’t qualify for deductible Traditional IRA contributions, or Roth IRA contributions due to income phaseouts can still add money to Roth IRA Accounts using a strategy called a Backdoor Roth conversion. The process sounds complicated, but it isn’t that complex. The interested taxpayer opens a separate IRA account funded with after-tax dollars. IRA accounts are not specifically designated as Traditional or Non-Deductible IRA accounts. These non-deductible contributions in the separate IRA account are reported to the IRS on Form 8606. This is crucial to avoid being double-taxed on those contributions when you withdraw funds in retirement. Form 8606 assures that contributions will not be double taxed. Earnings from a non-deductible IRA account are taxed when withdrawn, and may be subject to penalties if withdrawn early.
The strategy is not to leave money in the non-deductible IRA. The strategy is to fund the account with after-tax dollars and immediately do a Roth conversion. The Roth conversion becomes a balance transfer into a different Roth account with no tax implications (taxes were paid before the contribution was made to the Non-Deductible IRA. If the money is left in the non-deductible IRA for a while before the conversion, there may be applicable taxes owed on earned income inside the non-deductible IRA at the time of conversion). The back door Roth allows money to flow into a Roth IRA in situations where income limits prevent direct contributions.
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Late Career or Retired-
Workers can make Roth contributions as long as there is earned income that does not exceed the contribution guidelines. Workers can continue making Roth contributions as long as these contributions make sense within the scope of their finances and taxes.
The backdoor Roth strategy also diminishes in importance as earned income declines or stops, and direct contributions become easier.
Generally, as income diminishes or a person retires, the emphasis shifts from Roth contributions to Roth conversions.
Because Roth conversions are taxable events, opportunities to initiate Roth conversions while staying within certain tax brackets become easier as earned income diminishes or stops. Dollars converted from Traditional IRAs or Rollover IRAs are considered ordinary income and are added to other taxable income in the year the conversion is completed. This strategy becomes more attractive when income from work diminishes or stops, and these dollars are replaced by the dollars from Roth conversions. As stated above, there are income limits to Roth contributions, but no limits to Roth conversions. Taxpayers may be limited by the tax implications of Roth conversions, but these are self-imposed.
The potential drawbacks of doing Roth conversions later in life are taxes, age, and IRMAA. The bigger the Roth conversion, the more taxable income the conversion will generate.
Age is a factor because there is a crossover point where paying taxes early doesn’t make sense. It doesn’t make sense to pay taxes early when the same money could be passed tax-free to heirs after the taxpayer dies. The problem is that no one knows how long they will live after completing Roth conversions.
One of the biggest problems is IRMAA. IRMAA (Income Related Monthly Adjustment Amount) is a surcharge added to the base Medicare premium as income reaches certain levels. Since Roth conversions are treated as ordinary income, they increase taxable income and may affect Medicare premiums. The larger the Roth conversions, the greater the potential to affect IRMAA search charges and associated Medicare premiums. This is a concern for citizens receiving Medicare. This also accelerates the need to do Roth conversions before the initiation of Medicare coverage. IRMAA surcharges are calculated annually and there is a two-year look-back period. When a person turns 65 and qualifies for Medicare, the taxpayer’s tax returns at age 63 will be reviewed to determine if any IRMAA surcharge charges are applicable. This review is completed annually as long as Medicare benefits are received. This means an annual review for the rest of a taxpayer’s lifetime.
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Regardless of how it is accomplished, opening and funding a Roth IRA account is a smart decision that can benefit long-term net worth and retirement planning.
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Final Thoughts
Much has been written about Roth accounts, not all being complimentary.
Workers need to be selective as to how and when Roth accounts are funded.
Taxes are a big consideration surrounding Roth accounts as funding Roth IRA accounts are taxable events.
Roth accounts can be funded at any age, but certain strategies work better at certain points in a worker’s career.
Pain points may be associated with Roth accounts, as someone must pay taxes early and leave money in the account for the longest possible time to gain the greatest benefit.
The three main determinants of the validity of Roth funding are age, taxes, and the effect on Medicare premiums.
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