Who qualifies for a Roth IRA, plus the advantages and disadvantages

By Craig Eissler and Ross Langley 

Roth Individual Retirement Accounts (IRAs) are a great solution for saving for retirement if you have earned income and you’re anticipating higher taxes when you’re in retirement. These accounts can also be passed to your heirs tax-free.

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Here’s who can benefit most from a Roth IRA — and, if you exceed the current Internal Revenue Service income limits for one, how to use a backdoor conversion to a Roth from a traditional IRA.

The Roth IRA: Overlooked Cousin to the Traditional IRA

Roth IRAs are the often-overlooked cousin to traditional IRAs. Both retirement plans have their pros and cons. The Roth IRA was established by the Taxpayer Relief Act of 1997 and named after its chief legislative sponsor, Senator William Roth of Delaware.

With a Roth IRA, you make after-tax contributions (funds you have already paid taxes on) into your account. This lets you take all future withdrawals from the account in retirement tax-free. Because of the tax benefit on the back-end, there are no up-front tax deductions for Roth IRA contributions as there are with a traditional IRA.

Roth IRAs often make the most sense for those who expect their tax rate to be higher during retirement compared to their current tax rate, if they intend to draw on the Roth IRA funds. Given the current political climate this is, and likely always will be, somewhat of a moving target. But typically, Roth IRAs appeal to anyone who wants to minimize a retirement tax bite. Wealthy taxpayers who want to leave assets to their heirs tax-free also find Roth IRAs to be a great strategy.

Requirements for a Roth IRA

With these benefits come several requirements, including:

  • You must hold the Roth account for at least five years and be at least 59 ½ before you can tap the earnings tax-free and penalty-free. The good news is that there are no mandatory withdrawals or required minimum distributions beginning at age 70½ as there are with traditional IRAs. This is particularly useful for estate-planning purposes because it allows the account balance to continue to grow.
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  • Heirs pay no income taxes on inherited Roth IRAs.
  • Non-spousal heirs are required to take distributions from the inherited Roth IRA (either over their lifetime or a five-year period). But they stand to benefit from the tax-free, compounded growth from their benefactor’s contributions over potentially many decades.

Contribution and Income Limits for a Roth IRA

Where things get more complex are the income limitations for contributing to a Roth IRA as well as the rules surrounding converting traditional IRAs into Roths.

The maximum contribution allowed for either type of IRA for 2018 is $5,500 ($6,500 for those 50 and older). Keep in mind that, depending on your income level, being able to make a contribution to a traditional IRA does not necessarily mean it will be tax deductible.

As with most tax advantages and incentives for retirement plans, the Internal Revenue Service (IRS) maintains income-eligibility limits. For 2018, the ability for taxpayers to make Roth contributions is phased out within certain Modified Adjusted Gross Income brackets (beginning at $189,000 for married couples filing jointly and $120,000 for singles).

But there are other potential ways to enjoy the benefits of a Roth IRA.

One option is through an employer-sponsored retirement plan. Many plans allow employees to designate their deferrals as Roth rather than traditional pre-tax contributions, thus affording those dollars the same treatment as Roth IRA accounts.

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The Backdoor Roth IRA

Another option is called a backdoor Roth. If you’re a high-income earner and are not eligible to make direct contributions to a Roth IRA, you could be eligible for a backdoor Roth contribution. Backdoor Roths were made possible by a change in tax law in 2010 that lets taxpayers contribute to a traditional IRA and then immediately convert it to a Roth IRA.

When converting to a Roth IRA, any pre-tax dollars are taxable at the time of conversion, while after-tax dollars are converted free of income tax. If you are a high-income earner and made nondeductible contributions to your traditional IRA, that amount could be converted to a Roth IRA completely with no income-tax payment requirements. But you would have to pay taxes on any growth on these converted assets.

This version of the backdoor strategy is fairly simple for those who currently hold just one traditional IRA account. However the calculation of the taxable portion of the conversion becomes more complicated if you hold multiple IRAs with pre-tax balances. This is because of the IRS’s “pro-rata rule,” which aggregates all IRA accounts and calculates the taxable conversion based on the proportion between the total of after-tax and before tax dollars across all your traditional IRA accounts.

If you’re considering making this kind of conversion comprising multiple accounts, you would be well served to consult with a financial professional.

Nothing contained in this publication is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

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For more information or questions, please contact Halbert Hargrove at hhteam@halberthargrove.com.