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When Roth IRAs were introduced back in 1997, they revolutionized the way people save for retirement. Before, tax-deferred accounts like 401(k)s and traditional IRAs were designed primarily to shelter income from current taxation, with the trade-off that retirees would have to pay taxes on their withdrawals during retirement. The Roth, however, offers truly tax-free investment, with no taxes even on retiree withdrawals. That has made Roths popular, but income limits have limited some high-income taxpayers from using Roth IRAs. But with help from a recent ruling from the IRS, many retirement savers are going to find it a lot easier to use a Roth as part of their retirement planning.
Getting around Roth limits
Under current law, those who earn too much aren't allowed to make contributions directly to a Roth IRA. For single filers, having income of $129,000 or more makes you ineligible, and joint filers face a $191,000 income limit to contribute to a Roth.
But if you participate in an employer-sponsored retirement plan that allows you to make after-tax contributions, then there's a backdoor you can use to get into a Roth IRA. If you roll over your retirement plan assets, you can choose a Roth IRA as the destination for the rollover, and no income limits apply.
The problem with that strategy in the past has been that most people had a combination of pre-tax and after-tax contributions in their 401(k) accounts. There was no good way to separate out the pre-tax and after-tax portions into different types of rollover IRAs, and they had to pick whether they'd prefer a Roth IRA or a traditional IRA as the target for rolling over their plan assets.
As a result, savers faced two unappealing choices with the rollover strategy. If they chose a traditional IRA as the rollover target, then they wouldn't get tax-free treatment on the earnings from the after-tax portion of their assets -- effectively increasing their tax bill during retirement without any corresponding benefit. On the other hand, if they rolled over their retirement plan assets into a Roth IRA, they had to pay taxes immediately on the part of the account that represented pre-tax contributions. Either way, the results fell short of the best possible outcome.
Doing the IRS split
The IRS ruling last month on retirement rollovers makes things a lot simpler and more understandable for those using this strategy to get money into a Roth IRA. According to the new rules, you're now allowed to separate out your pre-tax contributions from your after-tax contributions and send them to different types of IRAs simultaneously. That makes it possible for you to open a Roth IRA for the after-tax portion of your retirement plan at the same time that you open a traditional IRA to receive your pre-tax retirement assets. Therefore, you eliminate the waste of not getting tax-free treatment on your after-tax contributions, and you avoid paying taxes on pre-tax money that would otherwise have ended up in your rollover Roth IRA.
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One thing to remember, though, is that the IRS ruling falls short of the perfect solution for retirement savers. Ideally, what many savers would want to do is to roll over just part of their existing 401(k)s, getting after-tax contributions into a Roth IRA as soon as possible but preserving their pre-tax money in the 401(k). That's not allowed under the notice, as you're required to separate out whatever dollar amount you roll over in proportion to the percentage of pre-tax and after-tax contributions in the account.
In addition, don't get confused between after-tax contributions to a regular 401(k) and contributions to a Roth 401(k). If your employer offers a Roth 401(k) option, then that will always be a better choice than a regular after-tax contribution, because any earnings from your Roth 401(k) assets will be free from tax from the first moment you make your account deposit. By contrast, while your after-tax money is in the 401(k), any earnings will be included in the taxable amount you pay when you withdraw funds -- even if those earnings came from your after-tax contribution.
Nevertheless, for those contemplating ways to get money into a Roth IRA without running afoul of the income limits, a 401(k) retirement plan rollover of after-tax contributions offers an interesting alternative. For some, it'll be the only available avenue to participate in the tax-free windfall that Roth IRAs provide.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
FAQs
The maximum amount you can contribute to a traditional IRA or Roth IRA (or combination of both) in 2024 is $7,000. So that's about $583 a month. If you're age 50 or over, the IRS allows you to contribute up to $7,500 annually (or $625 a month). Note that there are income limits for Roth IRA eligibility.
Why do rich people use Roth IRA? ›
Roth IRA. A Roth IRA is one of the best ways to minimize taxes. Many people earn too much to qualify for a Roth IRA. Not long ago, an alternative for high earners to minimize taxes while maximizing income came up that's known as the “Rich Person's Roth.”
What is the best strategy for a Roth IRA? ›
If you're building a Roth IRA to save for retirement, you'll want to design a portfolio using a long-term, buy-and-hold approach. A strong portfolio will be diversified across different asset classes, such as stocks and bonds, and across market sectors.
What is the income limit for a Roth IRA? ›
If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $153,000 for tax year 2023 and $161,000 for tax year 2024 to contribute to a Roth IRA, and if you're married and filing jointly, your MAGI must be under $228,000 for tax year 2023 and $240,000 for tax year 2024.
What if I max out my Roth IRA every year for 30 years? ›
How Much Can a Roth IRA Grow in 30 years? Over 30 years, if you invest the annual maximum of $6,000 into a Roth IRA in 2022, it could grow to $1.4 million.
How much can a Roth IRA grow in 10 years? ›
Let's say you open a Roth IRA and contribute the maximum amount each year. If the base contribution limit remains at $7,000 per year, you'd amass over $100,000 (assuming a 8.77% annual growth rate) after 10 years. After 30 years, you would accumulate over $900,000.
What income is too high for Roth IRA? ›
The consequences of a high income on Roth IRA contributions
If your income exceeds the cap — $161,000 for single filers, $240,000 for married couples filing jointly — you may not contribute to a Roth.
Is the backdoor Roth going away in 2024? ›
Yes. Backdoor Roth IRAs are still allowed in 2024. However, there has been talk of eliminating the backdoor Roth in recent years. And the future is, of course, difficult to predict.
What is better than a Roth IRA? ›
The main difference between a Roth IRA and a traditional IRA is how and when you get a tax break. Contributions to traditional IRAs are tax-deductible, but withdrawals in retirement are taxable as income. In comparison, contributions to Roth IRAs are not tax-deductible, but the withdrawals in retirement are tax-free.
What is the 4 rule for Roth IRA? ›
The 4% rule says people should withdraw 4% of their retirement funds in the first year after retiring and take that dollar amount, adjusted for inflation, every year after.
The best Roth IRA accounts include Vanguard, Fidelity, Charles Schwab, Merrill Edge and E*TRADE. They stand out for their low costs and large selection of retirement investments.
What is a backdoor Roth? ›
A backdoor Roth IRA is a strategy that high earners can use to contribute to a Roth IRA despite income limits. This strategy involves making non-deductible contributions to a traditional IRA and then converting those dollars into a Roth IRA.
Can you withdraw from Roth IRA? ›
You can withdraw contributions you made to your Roth IRA anytime, tax- and penalty-free. However, you may have to pay taxes and penalties on earnings in your Roth IRA.
What happens if I contribute to a Roth and made too much money? ›
Key Takeaways
You can withdraw the money, recharacterize the excess contribution into a traditional IRA, or apply your excess contribution to next year's Roth. You'll face a 6% tax penalty every year until you remedy the situation.
How much will Roth IRA be worth in 20 years? ›
If you contribute 5,000 dollars per year to a Roth IRA and earn an average annual return of 10 percent, your account balance will be worth a figure in the region of 250,000 dollars after 20 years.
Do Roth IRAs have monthly fees? ›
Account maintenance fees: Some Roth IRA providers charge a monthly or annual account maintenance fee (sometimes called a custodial fee). 3 The fee—and the dollar amount that you'll pay—should be disclosed in your account paperwork. If your provider charges an account maintenance fee, you might pay $25 to $50 per year.
How much should I put in my Roth 401k per month? ›
Most financial planning studies suggest that the ideal contribution percentage to save for retirement is between 15% and 20% of gross income.
How much should you have in a Roth IRA by age? ›
By age 35, aim to save one to one-and-a-half times your current salary for retirement. By age 50, that goal is three-and-a-half to six times your salary. By age 60, your retirement savings goal may be six to 11-times your salary. Ranges increase with age to account for a wide variety of incomes and situations.
