What is a Roth IRA? 

When it comes to making retirement plans, a Roth IRA is one of the best options available. Any money net of taxes put into a Roth IRA grows tax-free. Also, account holders don’t pay any taxes or penalties when they withdraw from it once they’ve retired or reached 59½ years old.  

In this article, we discuss crucial information about the Roth IRA: what it is, how it works, what the guidelines are on contributions and withdrawals. This article can serve as a client education piece when discussing Roth IRAs as a tax-saving strategy. 

What is a Roth IRA? 

Named after the late Delaware Sen. William Roth, the Roth Individual Retirement Account was created as a savings option for retirees in 1998. This was followed by the Roth 401(k) in 2006.    

Benefits of a Roth IRA 

Roth IRAs are like ordinary IRAs, but their main difference is how they are taxed. Roth IRAs are funded with after-tax dollars, so their contributions cannot be considered tax-deductible.  

Here are other benefits:  

1. no age restrictions for making contributions - if your client has a qualifying earned income, they can contribute to their Roth IRA regardless of age 

2. no tax on earnings - any contributions and potential investment gains are completely tax-free 

3. allows for qualified tax-free withdrawals - owners of the Roth IRA can make tax-free, penalty-free withdrawals if they are at least 59½ years old and meet the minimum account holding period of 5 years. 

4. no need for mandatory withdrawals - there is no need to take any required minimum distributions, unlike a traditional IRA 

5. no income tax on inherited Roth IRAs - if your client chooses to give their Roth IRA to their heirs, withdrawals will likewise not be subject to income tax 

Roth IRA vs traditional IRA 

There’s a number of key differences between the Roth IRA and the Traditional IRA. The table below offers an overview:  

Taxpayers who don’t need to withdraw their Roth IRA for their retirement can leave the money in it to appreciate indefinitely. After they die, the assets can go to their heirs, tax-free. 

Although the beneficiary has to take distributions from the inherited IRA, they can extend the tax deferral by taking these distributions for a decade. In some cases, they can do this for a lifetime.  

Meanwhile, Traditional IRA beneficiaries must pay income taxes on the distributions. However, if the beneficiary is the spouse, they can place the inherited IRA into a new account and not take any distributions until they turn 73.  

Here’s a video explaining further why a Roth IRA is better than a Traditional IRA:  

Roth IRA guidelines on contributions 

There are several important rules on contributions to a Roth IRA that your clients should know about. For starters, they can only put in cash, checks, or money orders – no securities or real property.  

A Roth IRA can be funded from several sources, including: 

• conversions 
• regular contributions 
• spousal IRA contributions 
• rollover contributions 
• transfers 

What’s more, the Internal Revenue Service places annual limits on how much money your clients can contribute to their Roth IRA. The contribution amounts for both the Roth IRA and the Traditional IRA are the same but are adjusted periodically.  

For instance, the yearly contribution limit set by the IRS for IRAs in 2023 is $6,500 for those aged below 50 and $7,500 for those aged 50 and over. In 2024, the limit will be raised to $7,000 for those aged below 50, and $8,000 for those aged 50 and over.  

When contributing to a Roth IRA, single taxpayers must have a Modified Adjusted Gross Income (MAGI) that amounts to less than $153,000 in 2023. But in 2024, that threshold increases to $161,000.  

Meanwhile, married couples who file their taxes jointly must have a combined MAGI of less than $228,000 in 2023 for them to contribute to the Roth IRA. In 2024, this threshold will increase to $240,000. 

The limits apply to all IRA accounts. Even if account holders have several IRAs, the contribution limit will have to be spread among them.  

The contribution limits largely depend on income, legal status, and the other contributions made to other IRA accounts. 

Withdrawal rules and penalties 

While it’s true that your clients can withdraw money from their account at any time, there can be penalties in some instances. The penalties depend on their age at the time of the withdrawal, and the “age” of the Roth IRA account.  

There are at least 4 possible scenarios for withdrawing from the Roth IRA that may trigger specific penalties:  

1. If the account holder is younger than 59½ and Roth IRA is less than 5 years old  

This is the worst case. The Roth IRA holder will owe income taxes and incur a 10% penalty if withdrawing earnings from an account held for less than five years.  

Your client can avoid the penalty (but not the income taxes) if the withdrawal meets one of these conditions: 

• does not exceed $10,000 to buy your first home 
• does not exceed $5,000 in the year after a child was born or adopted 
• used to pay for qualified education expenses 
• used to pay unreimbursed medical expenses that amounted to more than 7.5% of your adjusted gross income for the year 
• used to pay for health insurance premiums while unemployed 
• part of an IRS payment plan to satisfy an IRS levy 
• was made while you were a reservist 
• is for passing on to a beneficiary or your estate after your death 
• is necessary, due to a disability 

Penalties can also be avoided if your client decides to take equal payments. This means taking at least one distribution per year for at least 5 years or until they turn 59½, whichever is later. 

2. If the account holder is younger than 59½ and the account is at least 5 years old  

In this scenario, it’s possible to avoid taxes and penalties on withdrawals from a Roth IRA. The account must have been held for 5 years or more, and meet the following criteria:  

• the withdrawal is not more than $10,000 and it’s for buying a first home 
• the withdrawal is made after the account holder’s death and is intended for their beneficiary or estate 
• the withdrawal is necessary, due to a disability 

3. If the account holder is 59½ or older and the account is less than 5 years old 

Should your client own the Roth IRA for less than the requisite five-year period for exemptions, they will have to pay income tax. They don’t incur any penalty on earnings withdrawn.  

4. If the account holder is 59½ or older and the account is at least 5 years old  

This is ideal, as your client may withdraw earnings and contributions with neither tax nor penalty. 

What is the Roth IRA conversion?  

What is the Roth IRA conversion?  

The Roth IRA conversion is the process of transferring retirement assets from any of these accounts into a Roth IRA account:  

• Savings Investment Match Plan for Employees (SIMPLE) IRA 
• Simplified Employee Pension (SEP) 
• a 401(k)  

When doing this, the account holder must pay income taxes on the money they transfer. They do not have to pay taxes when they withdraw from the converted Roth IRA at a future date.  

Here are the ways that a conversion is done:  

1. Trustee-to-trustee transfer: Here, the assets are transferred from the financial institution or trustee of a traditional IRA to the one where the new Roth IRA will be held. Transfers to the same financial institution are also possible. This is known simply as a same-trustee transfer. 

2. Direct rollover: This is usually from a 401(k) or 403(b). A common scenario is when the account holder leaves a job or leaves an account with a former employer. To do this conversion, the plan's administrator sends money or issues a check for the new account. 

3. 60-day rollover: In this conversion, the money is simply paid to the account holder. They can deposit all or part of the amount in the Roth IRA within 60 days.  

What is a Backdoor Roth IRA conversion? 

A Backdoor Roth IRA is not a type of Roth IRA but is more of a strategy. It’s used by wealthier taxpayers to bypass the income limit for opening an account.  

As the traditional IRA has no income limits, wealthier taxpayers contribute to traditional IRAs, then convert them into Roth IRAs. Some advisors think this is a godsend for retirees.  

How to open a Roth IRA 

Knowing that a Roth IRA can be a good way to prepare for retirement, how can your client open one?  

1. They should be eligible and prepared  

Make sure your clients don’t go over the income limits. If their income is over the limits, your client can first set up a traditional IRA, then convert it to a Roth IRA. They should have the budget to make the contributions.  

Before setting up an account, a sound strategy would be to pay off all debts and put some savings in an emergency fund. Also, your client should take full advantage of their company’s 401(k) match. Only then should they consider investing in a Roth IRA.  

2. Pick a strategy for managing the account 

Should your client go DIY in managing the account or hire an experienced financial adviser? If they’re new to investing, they should work with an adviser like you. But even if they are a more experienced investor and would like to go DIY, they would still benefit from your expertise. There are some investment questions that a Chatbot or online search can’t answer the way a human adviser can.  

3. Get the necessary forms 

The required paperwork for a Roth IRA is the same whether your client signs up on their own or decides to work with you. They should have all the information (listed below) handy for filling out the forms: 

• Social Security number 
• driver’s license or other government-issued ID with photo 
• bank’s routing number and checking or savings account number 
• employer’s name and address 

Your client must also name a beneficiary (or beneficiaries) of their Roth IRA in case they die. Details like names, Social Security numbers and dates of birth should be on hand as well. 

4. Help your client choose the investments of their Roth IRA 

A Roth IRA simply contains investments and keeps them safe from capital gains taxes and income taxes. It’s not an investment in itself.  

A good strategy is to place mutual funds in your client’s account. Mutual funds are relatively low risk and have great potential for providing decent long-term earnings.  

5. Set up contributions to the Roth IRA

Your client should check if their employer offers an automatic contribution feature for the Roth IRA. When your client signs up for this, contribution amounts to their account are automatically deducted from their paycheck. They can ask their Roth IRA custodian for a routing number and account number.   

Would a Roth IRA work for your clients? 

The Roth IRA is a flexible tool for saving and retirement planning. It offers a number of tax-saving features but comes with specific guidelines as well. It’s important to highlight these details with your client when discussing Roth IRAs as an option for savings and retirement. 

Whether a Roth IRA or Traditional IRA makes more sense depends on the needs and preferences of your clients. Would they want to enjoy future tax benefits with a Roth IRA or reap the tax benefits now with a Traditional IRA? This is an important conversation to have with your clients. Your knowledge and expertise can help guide them in making the right financial decisions for themselves.  

Learn more about the rules for Roth IRA conversions here.

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