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[Video] Roth IRA Explained: Contributions vs. Conversions, and More Thumbnail

[Video] Roth IRA Explained: Contributions vs. Conversions, and More

Tim discusses the difference between Roth IRA contributions and Roth IRA conversions. He also outlines the benefits of Roth IRAs.

Quick answer: A Roth contribution is totally different froma Roth conversion. To make a Roth contribution, similar to any retirement plan contribution, you have to have “earned income.”

A Roth Conversion means you convert any pre-tax retirement account money, like a 401(k) or traditional IRA money, to a Roth IRA. And you can do this at any time, and any amount up to the full amount you have in your pre-tax retirement account, but you will have to pay ordinary income taxes on that money. 

So, Roth contributions and Roth conversions are two completely different ways to get money into a Roth IRA.

Now, for a bit more color, I’m going to discuss the benefits of a Roth IRA, Roth IRA distribution rules, and the Roth IRA contribution limits for 2024.

What is a Roth IRA?

A Roth IRA is just a title that's given to an investment account. By calling it a Roth IRA, the IRS assumes that you're going to follow the rules that they've put forward for the Roth IRA. A Roth IRA on its own is not really much, it's just an account. There's nothing inside of it. 

Think of it like a steel safe, that you might have in your home. You can have a safe that’s just empty, with no valuables in it. We must put stuff into that safe to help create some kind of a value. 

So, in a Roth IRA, you can basically have any type of investment inside of the account: stocks, bonds, mutual funds, gold, real estate, you're pretty much unlimited as far as the things that you can invest, a Roth IRA in. 

Just like a safe, the more assets you put in the Roth, the more value you get.

What Are the Benefits of a Roth IRA?

A Roth IRA is a retirement account funded with after-tax money. If the rules of a Roth account are followed, and the account is qualified, the earnings generated from the account can be withdrawn income tax free when you take it out later to spend. So, the longer money is compounding in a Roth IRA the more advantageous it becomes. 

Roth IRA Withdrawal (or Distribution) Rules

  • Since Roth IRA contributions are made after taxes, those contributions will not be taxed again. Your IRA Roth contributions can be withdrawn tax and penalty free regardless of when they are contributed. 
  • Now, Roth IRA earnings are a different story, (amounts above contributions) In order for the earnings to be qualified, two conditions need to be met: 
    • First, the account must be open at least 5 years* 
    • and second one of the following must apply: 
      • Your age is at least 59 ½  
      • Or you die and the money is withdrawn by your beneficiaries. 
      • Or you become disabled 
      • Or you use the money for a first-time home purchase, with a $10,000 lifetime cap 
  • Moving on, it’s also important to distinguish that you're never actually required to take money out of a Roth IRA. Required Minimum Distributions (RMDs) do not apply to Roth IRAs. Owners of traditional IRAs are required to take distributions at age 73 (age 75 if born in 1960 or later). Not the case with a Roth.  

* Note: It is not possible for a Roth to be qualified if the five-year holding period is not met. If you are over age 59 ½ and have not met the five-year holding requirement, your earnings (not contributions) will be subject to taxes but not penalties.

So, you ideally want to leave your money in a Roth IRA until you retire, right? That's the point of the account. But if something comes up and you need the money, you can take out money that you've contributed without paying a penalty or taxes. 

Roth IRA Contribution Limits  for 2024

Of course, any account that comes with certain advantages also comes with certain rules.

  • Total contributions to traditional and Roth IRAs combined for 2024 can't be more than $7,000 ($8,000 if age 50 or older). This is up from $6,500 and $7,500 in 2023. You don't want to go over the contribution limit, or you're going to have to pay a 6% excise tax, but a good advisor and custodian will stop you from doing that so that you don't have to pay the penalty.  
  • In 2024, if you make less than $7,000 (or $8,000 if over 50), then you can only contribute however much you make. This is called “earned income.” So, for example, if you only made $3,000 during the year, or have $3,000 of earned income, that's all you could contribute. That would be your limit.
  • You're actually not allowed to contribute to a Roth IRA if you make too much money. Roth contributions are phased out for taxpayers with modified adjusted gross incomes (MAGIs) of: $146,000-161,000 for single taxpayers and $230,000-240,000 for married filing jointly in 2024. 
  • If you have a spouse that's currently not working, they can still open a Roth IRA, but the IRS is going to use the working spouse’s income to determine limitations for contributions.
  • There is no age limit for contributing to a Roth IRA. You may contribute to a Roth IRA as long as you have earned income. The same is now also true for traditional IRAs starting in 2020 thanks to the SECURE Act.

If you have a retirement plan at work, like a 401(k), then you can still have a Roth IRA and contribute to it. 

Now, we love Roth IRAs at my firm, they can be great tax planning tools. And if you have a large pre-tax account, like a 401(k), 403(b) or traditional IRA, you’ll probably want to convert some of the money to a Roth IRA by doing strategic Roth IRA conversions.  

Remember, you can convert any pre-tax IRA money to a Roth IRA at any time, but you will have to pay ordinary income taxes on that money.  So, you probably won’t want to do it all at once.

For example, let’s say you’ve worked your whole life and you’ve built up $1 million in your 401(k). Then you retire and roll the 401(k) to a traditional IRA which is a non-taxable event. Then you could, hypothetically, convert that entire $1 million to a Roth all at once.  

But you probably won’t want to do that because you will get killed in taxes. It is likely you will want to “fill up lower tax brackets” in your gap years between retirement and RMD age so you can lower your lifetime tax liability. Check out my video on Roth conversions if you would like to learn more.

A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your situation. 

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