7 Incredible Benefits of Roth IRAs That Will Blow Your Mind!
Unveiling 7 Jaw-Dropping Secrets About Roth IRAs That Could Change Your Financial Game Forever!
A Roth IRA can be a great way to grow your money tax-free, but to make the most of it, you need to understand all the little details. In this article, I’ll share seven facts about Roth IRAs that many people aren’t aware of. This knowledge will hopefully help you become a better planner for your financial future.
Now the great thing about Roth IRAs is that the more money that you have in them, the more the retirement income can be tax-free later and the larger your account can grow. We all adore the features of Roth IRAs, but some other tiny guidelines and subtleties let us make even better use of them and prepare even more efficiently.
Tax-Free Penalty-Free Withdrawals
The first little-known truth regarding Roth IRAs is that you can withdraw any amount you contribute to them at any time without incurring penalties or taxes.
This varies significantly from the majority of other retirement accounts, such as IRAs or 401(k)s, where your withdrawals before the age of 59.5 incur a 10% penalty plus taxes. However, a Roth IRA operates differently: contributions can be withdrawn tax-free at any time. Whether you’re 20, 30, or 40 years old, you’re not restricted until age 59.5 to access your contributions. You have the freedom to withdraw the money whenever it’s needed. However, what is important to note is the accumulated earnings on those contributions remain off-limits until age 59.5.
Let’s illustrate this with an example: Suppose you consistently contribute $5,000 annually to your Roth IRA from age 20 to 30, totaling $50,000 in contributions. Additionally, let’s assume your investments generate $40,000 in earnings over that period, resulting in a total account balance of $90,000.
After reaching that point, you’re free to withdraw the initial $50,000 at any time without facing taxes or penalties. Ideally, you’ll leave them invested to continue benefiting from tax-free growth. However, if you ever need those funds, rest assured they’re accessible without any tax consequences. The other $40,000 in earnings ARE subject to taxes and penalties if withdrawn prior to 59.5.
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The 5-Year Rule
Now, onto the second aspect of Roth IRAs: the five-year rule. This rule dictates that to fully tap into the advantages of a Roth IRA, including tax-free growth, you not only need to reach the age of 59.5 but also must have held the account for at least five years from its initial funding date.
For example, let’s say you’re 60 years old and just discovering the benefits of Roth IRAs. You decide to open one.
Once you’ve funded your Roth IRA, you always have the option to withdraw your contributions tax-free, as we discussed earlier. However, accessing the growth requires waiting for a five-year period to pass. Only after this window has elapsed does the growth become accessible, even if you’re already past the age of 59.5.
But wait, there’s more to the five-year rule. For Roth conversions, there’s a separate five-year tax window for each conversion. This means that every time you convert funds to a Roth IRA, you’ll need to wait for that conversion amount’s five-year period to pass before those specific funds become eligible for withdrawal without taxes or penalties.
So, as you navigate Roth contributions and conversions, it’s crucial to keep track of when each account was funded and when each conversion occurred.
This scenario applies to any Roth account, whether it was initiated years ago or you’ve recently opened a new one. If you’re starting fresh with a new account, the clock for the five-year period begins ticking. After this account has been funded for five years, all subsequent contributions become eligible for withdrawal without penalties or taxes.
There Is A Method To Withdrawal Madness…
Moreover, when you decide to withdraw funds from your Roth IRA, the IRS follows a specific protocol. Contributions are prioritized first and can be withdrawn tax-free. Once all contributions have been withdrawn, conversions are next in line, following the chronological order of their conversions. Finally, any growth is withdrawn last. This is the sequence in which withdrawal funds are treated by the IRS.
Another thing to keep in mind is that some people might question the wisdom of funding a Roth IRA later in life, say at 60, 65, or even 70. But it’s crucial to understand that the real advantage of Roth IRAs doesn’t kick in immediately. Instead, it comes from the tax-free growth of your investments over time. The longer your money stays in the account, the more significant the benefits can become.
For most folks, this concern isn’t really an issue. When you’re doing Roth conversions, it’s not about converting funds and then immediately spending them. The idea is to take advantage of years of compound growth. Ideally, you’ll use these funds later in retirement, allowing them to keep growing tax-free until you need them. So while it might seem odd to fund a Roth IRA later in life, it can actually be a very smart move for long-term financial security.
Beneficiaries Are Not Immune…
As we’ve already discussed, there’s a five-year rule governing your initial contribution, and each conversion you undertake adheres to its own distinct five-year guideline. However, the five-year rule also applies to your beneficiaries. For instance, if you make your first Roth contribution today and pass away a few years later, your child who inherits the account must wait an additional three years for your initial five-year clock to expire before they can access the growth on that Roth IRA tax-free.
Try The Backdoor Route For Entry…
As for the third lesser-known fact about Roth IRAs: Even if your income is too high to contribute directly to a Roth IRA, you might still qualify for a backdoor Roth conversion.
Above, you’ll find the income thresholds for Roth IRAs. In 2023, if you make more than $153,000 (for single filers) or $228,000 (for married couples filing jointly), you can’t put money directly into a Roth IRA. These limits go up to $161,000 and $240,000 in 2024. This is where the option of a backdoor Roth conversion becomes relevant. If you exceed these income limits, you’re unable to contribute directly to a Roth IRA. However, you may still be eligible to execute a backdoor Roth conversion. This involves funding a nondeductible traditional IRA, which still has the same contribution limits, and then what you can do next is convert that after-tax balance into your Roth IRA. Since you’re transferring after-tax funds into an after-tax account, there are no taxes owed on that conversion. However, there are numerous details involved. You’ll need to file Form 8606 with the IRS to inform them of this transaction. It’s important to understand that if your income exceeds the threshold for direct Roth IRA contributions, you might still qualify for a backdoor Roth conversion.
RMD’s Do Not Apply
Moving on, another lesser-known fact about Roth IRAs is that they are not subject to required minimum distributions (RMDs). This is a significant advantage because the primary benefit of Roth IRAs lies in their tax-free growth. Since all the growth within a Roth IRA is tax-free, you’re not compelled to withdraw a certain amount each year once you reach a certain age, as is the case with traditional IRAs and 401(k)s.
With required minimum distributions (RMDs) on IRA or 401(k) balances, you’re compelled to withdraw larger portions of the account over time. This can lead to a decrease in the account balance or hinder its growth potential, unlike with Roth IRAs. With a Roth IRA, you don’t face this concern. You’re free to let the account balance continue growing for as long as you wish.
However, when your heirs inherit the Roth IRA, they are required to distribute it over a period of ten years. Despite this, you have the option to allow the account to keep growing. As of now, there are no required minimum distributions on Roth IRAs.
Not Included In Provisional Income Calculations
Another little-known detail about Roth IRAs is that they’re not included in provisional income calculations.
When calculating the taxable portion of your Social Security benefits, it hinges on a concept known as provisional income. Provisional income is a formula that considers various income sources. If these sources exceed specific thresholds, a greater portion of your Social Security benefits becomes part of your adjusted gross income. Now, if the bulk of your income originates from Roth IRAs — let’s assume all of it comes from either Roth IRAs or Social Security — this keeps your provisional income notably low. Consequently, while your Roth IRA withdrawals are already tax-free, this low provisional income might also render your Social Security benefits tax-free, as they fall below certain thresholds.
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When strategizing your tax planning, it’s important to recognize how Roth withdrawals not only affect your taxable income but also influence your provisional income, which determines the taxation of your Social Security benefits.
Medicare Surcharges CAN be reduced!
Additionally, the sixth lesser-known detail about Roth IRAs is their role in keeping your Medicare surcharges lower. Your adjusted gross income dictates your IRMAA surcharges, which essentially refer to the surcharges on your Medicare premiums, both Part B and Part D. The higher your adjusted gross income, the more of these surcharges you’ll be subject to. However, if a greater portion of your income originates from your Roth IRA, it keeps your adjusted gross income lower, thereby helping you reduce premium surcharges.
In retirement, your withdrawal strategy — whether it involves funds from your IRA, Roth IRA, Social Security, or pension — should be implemented strategically to stay within specific ordinary income tax brackets and IRMAA brackets. This approach helps minimize your Medicare surcharges as much as possible.
Your Spouse Counts!
Lastly, the final lesser-known detail about Roth IRAs is that even if you’re not earning any income yourself, you’re still eligible to make Roth IRA contributions as long as your spouse has earned income. Whether one spouse is a stay-at-home partner or already retired, as long as one spouse has income and you both fall within the income limits, both of you can contribute to Roth IRAs.
This is crucial because the more you can contribute to Roth IRAs, taking into account your priorities and other financial goals, the greater tax-free income you can have in retirement. And with more tax-free income, your retirement lifestyle can be significantly enhanced. It can be a win-win situation all around.
Remember, you’re eligible to make a spousal IRA contribution even if you have no earned income yourself, as long as your spouse does. Both spousal IRAs and spousal Roth IRA contributions are available as long as one spouse has earned income. These are seven lesser-known facts about Roth IRAs that can greatly impact your retirement planning and financial future.
The Bottom line
Understanding these facts empowers you to make the most effective use of Roth IRAs in your financial planning. As mentioned earlier, while backdoor Roth conversions offer significant benefits, they involve intricate details that must be handled correctly. Mistakes or oversights in this process can result in significant costs.
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Joe A. Macek, FMA, CIM, DMS, FCSI
Investment Advisor, Portfolio Manager
iA Private Wealth | iA Private Wealth USA
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