ROTH IRAs and Why They Make Sense

My Comments: They’ve been around for some time now, but because they cause you to use after-tax money, there’s always been a cloud around them. That’s a shame since they make sense when it comes to tactically allocating your retirement income among different sources and types of accounts.

That retirement, assuming you live a normal life, could last many, many years. During each of those years there are going to be unexpected events, some of which can be disruptive. Right now we’re in the middle of a massive health crisis that no one expected four months ago. We’ve long ago learned that S**T happens from time to time and there’s no reason to think we’ll be dead before the next one.

Meanwhile, back to the Roth IRA idea. There are some rules about them that we all need to understand. It can be a great long term investment if you manage it the right way. If you’re still looking at a few years between now and your retirement, here’s a useful summary about Roth IRAs you should read.

By Jeff Rose \ 8 MAR 2020 \

Whether you’re contemplating opening a Roth IRA, or you already have one in place, there are five things you need to know to make the account work for you the way it should.

1.  How Much Can You Put into a Roth IRA?

For 2020, the maximum contribution to a Roth IRA is $6,000 per year. But if you’re 50 or older, that increases to $7,000 per year.

There is a bit of a catch with that contribution. It’s only available to those who have earned income. That includes income from salaries, wages, commissions, bonuses, self-employment, freelance and contract work. For example, if you have $20,000 in earned income, you can make the full contribution allowed. But if you only earn $4,000, that will be your maximum contribution.

The $6,000/$7,000 contribution has another limit – that’s the most you can contribute to one or a combination of IRA accounts. That includes both Roth IRAs and traditional IRAs.

It means if you contribute the full $6,000 to a Roth IRA with one broker, you cannot make contributions to a second. By contrast, you can split your contribution between two brokers, with $3,000 going into each account.

2.  Set Up Roth IRA Accounts for Your Spouse and Kids

Most people are unaware that you can have a Roth IRA account for anyone and everyone in your family who has earned income.

In fact, there’s even an exception for your spouse. Under a spousal IRA, you can make a contribution of up to $6,000 (or $7,000 if 50 or older) even if your spouse has no earned income. Under this special type of IRA, you can make a contribution to Roth or traditional IRA accounts for both you and your spouse, as long as you have sufficient earned income to support both contributions.

For example, if you make $100,000 per year and your spouse does not have earned income, you can make a contribution of $6,000 to a Roth IRA account for both you and your spouse, for a total of $12,000.

By contrast, if you only earn $10,000, that will be the maximum contribution you can make to the two accounts combined.

To qualify for the spousal IRA, your partner must be your spouse. It can’t be a girlfriend, boyfriend or fiancé.

But it doesn’t stop with your spouse. If any of your children have earned income, you can open a custodial Roth IRA for that child. The contributions will be eligible if your child has a part-time job, or earns money from babysitting, lawn cutting, or similar activities.

One limitation however is that if the income received is not reported to the IRS, it won’t qualify for contributions. Contributions are based on income declared on your income tax return.

I’m doing this with my own children. Since I have a business, I have my kids work for me, for which I pay them. I then make a contribution to each child’s custodial Roth IRA up to the amount of income they earn. It’s a way of creating a portfolio of tax-free money for their futures.

3.   Getting Phased Out

The IRS puts an income ceiling on your ability to contribute to a Roth IRA. If you earn in excess of that ceiling, you won’t be able to contribute to a Roth IRA.

This is very different than traditional IRAs, where the contribution is no longer tax-deductible if you’re covered by an employer-sponsored retirement plan and your income exceeds a certain level. In that case, you can still make a contribution to a traditional IRA – it just won’t be tax-deductible.

That’s not the case with the Roth IRA. If you exceed the income thresholds set by the IRS, you won’t be able to make a Roth IRA contribution, period.

The current income limits beyond which you can no longer make a Roth IRA contribution are as follows:

  1. Single, full contribution up to $124,000, partial contribution up to $139,000, after which no contribution is allowed
  2. Married filing jointly, full contribution of two $196,000, partial contribution up to $206,000, after which no contribution is allowed

But there are a couple of workarounds. For qualification purposes, your income for the Roth IRA is based on what’s known as modified adjusted gross income, or MAGI.

One of the modifications to MAGI are tax-deductible 401(k) contributions. If you’re making contributions to an employer-sponsored plan, which are tax-deductible, they’ll also reduce your MAGI. It’s possible those contributions will reduce your income sufficiently to qualify you to make Roth IRA contributions.

To give an example, if you’re a single person making $139,000 per year – which would disqualify you from making a Roth IRA contribution – but you contribute $19,500 to your company-sponsored 401(k) plan, your MAGI will drop to $119,500. You’ll be allowed to make at least a partial Roth IRA contribution.

There’s also a second workaround, but it’s a bit more complicated.

The “Backdoor” Roth IRA

This kind of Roth IRA contribution is referred to as backdoor because it starts out as a contribution to a traditional IRA.

As I wrote earlier, there’s no income limitation on making a contribution to a traditional IRA. The only limit applies to the tax deductibility of the contribution if you’re covered by an employer plan and your income exceeds a certain limit.

But the basic idea of a backdoor Roth IRA is that you make a full contribution to a traditional IRA. The contribution is made on a non-tax-deductible basis. That’s really the key to the whole strategy.

Since you can convert a traditional IRA to a Roth IRA at any time, you can contribute to the traditional account, then do an immediate conversion to the Roth IRA.

Now any time you do what’s known as a Roth IRA conversion – which is the term for converting a traditional IRA or other tax-deductible retirement plan to a Roth IRA – you have to pay tax on the amount of the converted balance.

However, in the case of a backdoor Roth IRA, you won’t pay tax on the conversion from your traditional IRA contribution to your Roth IRA plan. That’s because the traditional IRA contribution was never tax-deductible in the first place. Since there’s no tax benefit when the contribution was made, there’s no tax liability when it’s converted to a Roth IRA.

4.  Roth IRA Contributions

Remember how I said contributions to a Roth IRA are not tax-deductible? That comes with its own benefit.

Since the contributions are not tax-deductible, they can be withdrawn at any time free from both ordinary income tax and the 10% early withdrawal penalty that typically applies when you withdraw funds from retirement account before turning 59 ½.

Now the income you earn from investments on your Roth account is treated like withdrawals from any other retirement plan. If any of that money is withdrawn before turning 59 ½, you’ll be subject to both ordinary income tax and the penalty.

But under IRS ordering rules, you can withdraw your contributions from a Roth IRA before your accumulated investment earnings.

Unlike other retirement plans, where you must tie-up your money for decades, or face taxes and penalties, the Roth IRA allows you to access your contributions at any time.

There’s one limitation you should be aware of when it comes to early withdrawals. If the value of your Roth IRA falls below your total contributions, you’ll be limited to withdrawing the net value of the account – not the amount of your original contributions.

5.  How Do You Invest in a Roth IRA?

One of the biggest mistakes people make with the Roth IRA is holding it with banks or credit unions. If you do, your money will be held in low-yielding investments, like certificates of deposit and money market accounts. Those don’t pay any more than 1% or 2% per year. They’re not the kinds of investments that will cause your Roth IRA to grow the way it should.

A Roth IRA is a retirement account, which means you need to invest with the long-term in mind. And since you probably have decades to invest, you’ll need to add high risk/high reward investments to the mix. That includes stocks, mutual funds, exchange traded funds, real estate investment trusts, and similar investment vehicles. To do that, you’ll have to move your plan to the right investment account.

You’ll need investments designed to generate long-term growth. For example, the average annual return on stocks has been 10% going all the way back to the 1970s. If the majority of your Roth IRA is invested in stocks, your account will grow quickly, and produce a healthy retirement nest egg by the time you’re ready to begin making withdrawals.

The Roth IRA is one of the greatest investment vehicles ever designed. If you don’t have it in your financial toolbox you need to add it. Just make sure you fund it regularly, and invest it aggressively to get the best results.