What is a Roth IRA? Fundamentals & Conversions (2024)

Key Takeaways:

• Roth IRAs are funded with after-tax dollars and are generally not subject to tax upon distribution, making long-term deferral of Roth distributions a powerful income tax planning strategy.
• Roth IRA accounts come with unique benefits outside of future tax savings. There are no minimum distributions required of a Roth IRA in the account owner’s lifetime. Additionally, owners can make contributions to a Roth IRA as long as they are receiving taxable income.
• Roth IRA contributions are subject to income caps. However, all taxpayers are allowed to convert their Traditional IRAs, as well as other eligible retirement plan accounts, to Roth IRAs, regardless of income or filing status. Eliminating the conversion limitations effectively permits anyone to fund a Roth IRA by simply contributing limited, non-deductible annual amounts to a Traditional IRA and thereafter converting that account to a Roth IRA.

What is a Roth IRA?

Roth individual retirement accounts (Roth IRAs) are qualified retirement plans introduced by Congress in 1998, under IRC Section 408A.

Roth IRAs are distinct from Traditional IRAs in many ways. The primary difference is that Traditional IRAs are funded with pre-tax dollars and distributions are subject to income tax. Roth IRAs are funded with after-tax dollars, and generally are not subject to tax upon distribution.

Because investments in a Roth IRA grow tax-free and are not subject to income tax upon distribution, long-term deferral of Roth distributions can be a powerful income tax planning strategy. The longer assets remain in a Roth account, the greater the opportunity for tax-free growth, and ultimately tax-free income for the account owner or beneficiaries.
This article discusses tax deferral opportunities as well as the fundamentals of Roth IRAs and Roth conversions and explores the key considerations and planning opportunities with Roth IRAs and conversions.

Roth IRAs are qualified retirement plans funded with after-tax dollars and generally are not subject to tax upon distribution.

Fundamentals

Roth IRAs share many traits with Traditional IRAs. Both are:

• Held at custodian financial institutions;
• Subject to limitations on contributions, rollovers and distributions;
• Generally, not subject to income tax while assets remain in a qualified account; and
• Usually disposed of at death by a beneficiary designation.

How Does it Differ from Traditional IRAs?

Key differences between these two types of IRAs include:

• Contributions to a Roth IRA are non-deductible for income tax purposes, whereas contributions to a Traditional IRA can be deductible (subject to certain limitations);
• Qualified distributions from a Roth IRA are generally income tax-free, whereas withdrawals from a Traditional IRA (other than basis) are taxed as ordinary income; and
• There are generally fewer restrictions on withdrawals from Roth IRAs than from Traditional IRAs.

Contributions

There are two primary ways an individual can contribute to a Roth IRA:

• An individual with compensation income may make a regular contribution to a Roth IRA, subject to adjusted gross income limitations; and
• A participant who owns a Traditional IRA can roll over funds from the IRA to a Roth IRA, which is called a conversion.
• In addition, there are several less common ways to fund a Roth IRA, including a rollover of a designated Roth account and a designated beneficiary rollover from an inherited IRA to a Roth, among others.
• At age 73, the owner of a Traditional IRA must begin withdrawing required minimum distributions (RMDs). In contrast, RMDs are not required from Roth IRAs.
  

Annual Contribution Limits

In 2023, the maximum permitted contribution to a Roth IRA is $6,500. Individuals over the age of 50 may contribute an additional $1,000 per year as a “catch-up” contribution. The following contribution limitations also apply:

• A participant may contribute to a Roth IRA only if he or she has qualifying income in an amount no less than the amount of the contributions. “Qualifying income” is income from employment and alimony (if pursuant to a separation instrument signed before December 31, 2018) and does not include investment income.
• The maximum amount a participant may contribute to a Roth IRA is reduced by the amount the participant contributed to a Traditional IRA during that same tax year.
• The amount a participant may contribute is further limited by and phased out based on the participant’s modified adjusted gross income (MAGI) as summarized in the chart below for tax year 2023. The contribution limitation begins to be reduced when a participant’s MAGI exceeds the MAGI floor and is completely phased out when MAGI exceeds the MAGI ceiling.
  

https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022

There is no age limitation for contributions to a Roth IRA, as is the case with Traditional IRAs in a post-SECURE Act1 era. Participation in an employer plan is only relevant when determining whether a contribution to a Traditional IRA is deductible.

The deadline for contributing to a Roth IRA is the same as the deadline for contributing to a Traditional IRA, i.e., the unextended due date of the tax return for that year, which is generally April 15 of the following year.

Distributions

No RMDs for Participants

In the case of a Traditional IRA, at the age of 73, the participant must withdraw annually a minimum amount, the RMD. In contrast, a participant of a Roth IRA is not required to take any distributions from the Roth IRA during his or her lifetime.

Taxation of Roth IRA Distributions and Ordering Rules

Distributions from Roth IRAs are deemed to come from the following sources, in the order indicated:

• Contributions: First, the participant is considered to have withdrawn his or her annual contributions. This is a return to the participant of already taxed amounts and is therefore not taxable.
• Conversions: Next, the participant is considered to have withdrawn amounts that were “converted” from a Traditional IRA. Again, because these amounts have already been taxed, this is a return to the participant of previously taxed amounts and there are no income tax consequences.
• Earnings: Finally, once contributions and conversions have been exhausted, the earnings portion of the account balance is distributed. Generally, a distribution of earnings is tax- free if it is a “qualified distribution.”

In most cases, these ordering rules are relevant only to determine to what extent a distribution is subject to income tax, when some portion of the distribution may be a nonqualified distribution.

Qualified Distributions

A qualified distribution is any distribution made no sooner than five years after January 1 of the year in which the participant makes his or her initial contribution to the Roth IRA, and is distributed to any of the following:

• The account owner on or after attaining age 59 ½
• A beneficiary or the participant’s estate,
• A beneficiary who is considered disabled, as defined in the statute, or
• A qualified first-time homebuyer (limited to $10,000).

Inherited Roth IRAs

When the Roth IRA owner dies, the Roth IRA becomes payable to the Roth IRA designated beneficiary. Different rules apply when the beneficiary is a surviving spouse or a non-spouse beneficiary.

Spouse as Beneficiary

A Spouse Beneficiary has the following options when inheriting a Roth IRA, depending on if the participant’s death occurred prior to or after the required beginning date:

• Spousal Rollover: The surviving spouse may treat the Roth IRA as his or her own. Like the decedent, the surviving spouse is not required to take any distributions from the Roth IRA during the surviving spouse’s lifetime. For “qualified distribution” purposes, the five-year period would begin to run on the earlier of (i) the decedent/participant’s initial date; or (ii) the surviving spouse’s initial date, if the surviving spouse had his or her own separate Roth IRA.
• Continuing Roth: The surviving spouse may keep the account as an inherited account and treat the Roth IRA as if it was the decedent/participant’s Roth IRA and begin taking RMDs when the participant would have turned 73.
  • If the participant died prior to the required beginning date for taking RMDs, the surviving spouse can either (i) fully withdraw the inherited Roth IRA by December 31 of the tenth year following the death (the ten-year rule), or (ii) distribute the Roth IRA balance over the surviving spouse’s life expectancy (the life expectancy rule).
  • If the participant died after the required beginning date, the surviving spouse must take distributions following the life expectancy rule (he or she cannot follow the ten-year rule).

Non-Spouse Beneficiary

The options available to non-spouse beneficiaries depends on if the beneficiary is an Eligible Designated Beneficiary, a Designated Beneficiary, or a Beneficiary that is not an individual. An Eligible Designated Beneficiary is (i) a spouse or minor child of the decedent/participant; (ii) a disabled or chronically ill individual; or (iii) an individual who is not more than 10 years younger than the participant. A Designated Beneficiary is an individual who is not an Eligible Designated Beneficiary. The following options are available to these non-spouse beneficiaries:

• Ten-Year Rule: The ten-year rule is the default rule governing the distribution of inherited Roth IRA assets to Designated Beneficiaries, which provides that the entire amount of the inherited Roth IRA must be distributed by December 31 of the tenth year after the participant’s death. Eligible Designated Beneficiaries may choose to follow this ten-year rule only if the participant died prior to the participant’s required beginning date for taking RMDs.
• Five-Year Rule: The five-year rule is the default rule governing the distribution of inherited Roth IRA assets to Beneficiaries that are not individuals (such as to the participant’s estate), which provides that the entire amount of the inherited Roth IRA must be distributed by December 31 of the fifth year after the participant’s death.
• The Life Expectancy Rule: For Eligible Designated Beneficiaries the life expectancy rule permits withdrawals over the beneficiary’s “life expectancy” based upon the IRS Uniform Lifetime Tables. This beneficial rule can only be used by an “Eligible Designated Beneficiary.” If the Eligible Designated Beneficiary elects to use the life expectancy rule, then the Eligible Designated Beneficiary must begin taking RMDs from the IRA on or before December 31 following the year of the participant’s death.

Conversions are another common funding method, used to transfer funds to a Roth IRA from a Traditional IRA or non-IRA qualified plan such as a 401(k), 403(b) or 457 plan account.

Conversions

Conversions are another common funding method, used to transfer funds to a Roth IRA from a Traditional IRA or non-IRA qualified plan such as a 401(k), 403(b) or 457 plan account.

Generally, a conversion triggers income tax equal to the value of the assets converted from the Traditional IRA on the conversion date. As originally enacted, there were significant limitations that prevented high-income earning taxpayers from (i) contributing to a Roth IRA and (ii) converting Traditional IRA assets to a Roth IRA. Beginning in 2010, there are no limitations for Roth conversions; however, limits for contributions still apply.

Taxpayers may convert any part or all of their Traditional IRAs. Conversion of SEP-IRA or a SIMPLE IRA accounts may be achieved by transferring assets from the Traditional IRA to a different account that is a Roth IRA. Note that with respect to SIMPLE IRAs, the taxpayer must satisfy a two-year waiting period, beginning when the account holder first participated in his or her employer's SIMPLE IRA plan, before transferring the assets to a Roth IRA.

Key Details for Roth IRA Conversions

• Age: Any IRA owner may convert a Traditional IRA to a Roth IRA, regardless of age. However, the following rules apply: If the participant is under the age of 59-1/2, he or she may be subject to the 10% penalty on early distributions on certain post-conversion distributions, and

1. If the participant is under the age of 59-1/2, he or she may be subject to the 10% penalty on early distributions on certain post-conversion distributions, and
2. An individual who is turning (or is past) age 73 in the conversion year must take the RMD for that year before converting any money from the account to a Roth IRA.

• Tax Treatment: The amount of a Traditional IRA that is converted or rolled over to a Roth IRA is taxed exactly as if it had been distributed from the Traditional IRA and not rolled over. It is therefore included in the participant’s gross income. There is one significant exception to this rule: the participant’s own after-tax IRA contributions are not taxable when distributed to him or her, or converted to a Roth IRA.
• Pro-Rata Rule:How the IRS accounts for after-tax and pre-tax funds in an IRA when the taxpayer is engaging in a partial Roth conversion is referred to as the pro-rata rule, also called the IRA Aggregation Rule, under IRC Section 408(d)(2). The pro-rata rule is used to determine the after-tax amount of a Roth conversion when the taxpayer has both pre-tax and after-tax balances in his or her IRA(s). The pro-rata rule does not apply to Roth IRA distributions, which are subject to the ordering rules discussed above. For example, some participants may have made non-deductible contributions to their Traditional IRAs during life, therefore creating “basis” in the IRA. Upon conversion, the pro-rata rule provides that (a) the account owner must aggregate all of his or her IRAs together, and (b) the pro-rata share of the basis in the aggregate amount of the IRAs will be allocated to the conversion.

Company-sponsored plans such as 401(k)s and 403(b)s are not used in the pro-rata calculation, unless rolled over to an IRA in the year of conversion. Finally, SEP IRA values and SIMPLE IRA values are included in the definition of all IRAs. Although these types of accounts are company-sponsored, they must be included in the pro-rata calculation. However, an inherited IRA is not accounted for in the pro-rata rule formula.

Prior Conversions

There is no limit on the number of times participants may convert all or part of their Traditional IRA to a Roth IRA. Therefore, participants are free to convert in the same year or during future years using the same IRA account or converting assets from a different IRA than the one previously converted.

Conversions Limitations

Historically, there were significant limitations that prevented high-income earning taxpayers from (1) contributing to a Roth IRA and (2) converting Traditional IRA assets to a Roth IRA. Effective since 2010, there are no longer tax filing status or income level tests limiting eligibility for executing a Roth conversion. As such, anyone may convert without regard to his or her income tax filing status or income level.

However, by lifting the income limits on conversions, Congress effectively eliminated the income limits on contributions to Roth IRAs as well, by making possible a two-step process that circumvents those limits. The Roth conversion rules now effectively permit anyone to fund a Roth IRA by simply contributing pre-tax amounts to a Traditional IRA and thereafter converting that account to a Roth IRA.

Anyone may convert Traditional IRA assets to a Roth IRA without regard to his or her income tax filing status or income level.

Deadline for Conversion Contribution

Because a Roth conversion is technically a “rollover” of Traditional IRA assets to a Roth IRA, the rules governing the deadline for re-contributing conversion of assets from the Traditional IRA to the Roth IRA is subject to the same deadline that applies to Traditional IRA rollovers.

Therefore, a Roth conversion that is supposed to be “for” the year 2023 must be contributed within 60 days after the date of the distributions. The due date for the 2023 tax return is irrelevant (unlike for a regular contribution). Roth conversions are usually accomplished by transferring sums directly from a traditional plan or IRA into a Roth IRA. If both accounts are with the same administrator, the traditional plan distribution and the Roth IRA contributions would normally occur simultaneously.

Legacy Conversion Contribution

While a conversion is generally considered in terms of the benefits it may provide the account owner during life, the benefits of a Roth account may be preserved for the beneficiaries after the account owner has passed away. A Roth conversion may be as much an estate planning opportunity for the plan participant as it is a retirement and income tax strategy during the participant’s lifetime.

First, no income tax is due on withdrawals from Roth IRAs, whereas annual withdrawals from a Traditional IRA are subject to income tax. Therefore, the original investment in the Roth IRA will potentially continue to grow tax-free for the beneficiaries. This benefit with Roth assets contrasts with Traditional IRA assets, which are subject to income tax when inherited by non-spouse beneficiaries.

Second, when Roth IRAs (like Traditional IRAs) are included in the account owner’s taxable estate upon death, the estate may elect to pay the estate tax attributable to IRA assets from non-IRA assets, thus permitting all of the Roth IRA assets to remain in the tax-deferred Roth account for the benefit of the IRA beneficiaries.

Third, for participants living in states with income, inheritance or estate taxes, there is a complex interplay between the (i) the federal income tax and (ii) estate tax attributable to the inclusion of a Traditional IRA in a decedent’s taxable estate. There is no such issue with a Roth IRA, because there is no income tax due on the Roth IRA upon the participant’s death or at any point thereafter.

Therefore, a Roth conversion during life, and payment of the resulting income taxes during life, is generally the better option than paying income taxes post- death, particularly when the account owner may be subject to state income, inheritance or estate tax. The Roth’s tax-free growth and accumulation, plus income tax-free distributions to beneficiaries after the death of the account owner, are powerful income tax benefits for the beneficiaries after the account owner’s death.

A Roth conversion during life, and payment of the resulting income taxes during life, is generally the better option than paying income taxes post-death.Recharacterization Rule: Unwinding a Roth Conversion

Prior to 2018, Roth account owners were permitted to unwind a Roth conversion, subject to certain time constraints. The “recharacterization rule” generally allowed an IRA owner to unwind a conversion if the conversion occurred before filing a timely-filed income tax return. However, unwinding a Roth conversion is no longer permitted. Legislation enacted in December 2017 repealed the statute that authorized a Roth recharacterization.

Factors to Consider When Converting

Ultimately, the decision to covert a Traditional IRA to a Roth IRA comes down to your current personal financial situation and your desired financial position in the future. Below summarizes the major factors to consider when converting.

*Further analysis of the specific statutory asset protection for ERISA plans and state statutory exemptions is required.

Want to Know More?

Comerica welcomes the opportunity to help. If you would like to know more about Roth IRAs or any other wealth consideration, contact your Comerica Relationship Manager or request a Comerica Wealth Professional contact you at comerica.com/knowmore.