Roth IRAs and Roth Conversions

A Roth IRA is a tax-advantaged investment retirement account designed to encourage saving for retirement. Roth IRAs enable tax-free growth, tax-free withdrawals after age 59½, and do not mandate a required minimum distribution (RMD) and thus compound indefinitely.

Demystifying Roth IRAs

Roth IRAs enable tax-deferred savings for retirement by allowing an individual to contribute after-tax funds to an account and grow them tax-deferred forever, unlike a traditional IRA where funds are eventually taxed. A Roth IRA has three primary benefits:

1. Roth IRAs enable tax-free growth. While most people are working, they are in what is referred to as their accumulation phase, where they are saving for retirement and likely in their highest income (and thus tax) years. Saving through a Roth IRA enables the account to grow undiminished by taxes. Planning tip: You may consider using an asset location strategy for your Roth IRA by placing the riskiest, most tax inefficient assets with the highest growth potential within your Roth. 
2. Roth IRA withdrawals are tax-free after age 59½ (assuming the account has been open at least five years). In other words, you pay taxes on your contributions, but you do not pay taxes on any of the compounded growth or principal as you withdraw funds, as you would with a traditional IRA.

The chart below demonstrates how the two accounts compare on an after-tax basis in retirement. While this chart simplifies a real-world scenario by assuming only one contribution of $6,000, the ultimate after-tax account value is higher for the Roth IRA.

* Assuming an 8% annual return along with a 22% tax rate at age 30 and 32% tax rate at age 75. Taxes are applied to the Roth IRA at the time of contribution and to the traditional IRA at withdrawal.

3. Roth IRAs are not subject to required minimum distributions (RMD), which allows investments to continue compounding throughout the account owner’s lifetime – unlike traditional IRAs and 401(k)s that require you to withdraw a certain amount annually and thus pay taxes once you reach your required beginning date (age 75 for those born in 1960 or later). You can tap into Roth IRA funds if needed or simply allow the funds to grow tax-free, presenting a potential wealth transfer vehicle for heirs. Planning tip: Roth IRAs allow for a tax-free inheritance to heirs without annual RMDs. For Roth IRAs inherited since 2020, however, most non-spousal beneficiaries must distribute the account within ten years.  

Who Benefits Most from a Roth IRA?

Roth IRAs are attractive if you expect your marginal tax rates to stay the same or increase — either by being in a higher tax bracket in retirement or if you expect taxes to rise. While no one can predict future tax rates, modern marginal income tax rates are lower relative to historical rates.  

Source: Tax Policy Center

Roth IRAs tend to be an attractive retirement investment vehicle for those earlier in their careers, because the income limitations exclude higher earners. See specifics below. For younger investors, Roth IRAs are an attractive vehicle for growth-oriented assets , where investment gains are not taxed or withdrawn, as is the case with a traditional IRA. Famously, Peter Thiel, the founder of PayPal, invested his $2,000 Roth IRA in 1999 in PayPal and subsequently in Facebook, which allowed him to amass over $5 billion in tax-free savings.
Planning tip: If your child has earned income, consider assisting them with funding a Roth IRA. Children under 17 can also take advantage of compound growth with a custodial Roth IRA subject to income limitations.

A Final Consideration

The benefits of investment diversification across asset classes (stocks and bonds), sub-asset classes (large and small companies), sectors (technology and industrials), etc. have been extensively discussed within the context of the efficient frontier and modern portfolio theory. Another type of diversification, however, that is often overlooked is tax diversification. Having the ability to source funds that are not subject to taxes and available to you in tax-deferred vehicles (such as IRAs and 401(k)s) and tax-exempt accounts (such as Roth IRAs) allows for more liquidity options in different market and regulatory environments.

Roth IRA FAQ — My Income Level Prevents Me from Making a Roth Contribution. What Are My Options?

Consider Roth Conversions — Convert existing funds from a traditional IRA into a Roth IRA by paying taxes upon conversion and then benefit from a Roth IRA’s tax-free withdrawals.

You can consider moving funds housed in a traditional IRA into a Roth IRA. This strategy will allow you to capitalize on the benefits of the tax-free growth of a Roth IRA, but you will pay taxes on the converted portion. Be aware that the IRS considers the proportion of pre- and after-tax contributions made to IRAs by applying a pro-rata rule to account for the different contributions. Thus, a Roth conversion is simplest and most tax effective for those without existing pre-tax IRA contributions. Also note that the IRS considers all your IRAs in aggregate, so pre-tax contributions to 401(k)s that have been rolled into IRAs are included in the pro-rata rule calculation. We recommend consulting your tax preparer to determine if this is an appropriate strategy for your situation.  

Backdoor Roth Strategy — Fund a Roth IRA even if you are above the income threshold by first contributing to a traditional IRA and then immediately converting the funds into a Roth IRA.

Alternatively, you can employ a backdoor Roth strategy. If you do not have an existing IRA, you can contribute after-tax funds to a traditional IRA. Then, you can convert the funds through the “backdoor” into a Roth IRA. Because the traditional IRA contributions are made with after-tax funds, no income tax is owed with the conversion. The ability to contribute to a traditional IRA is also not subject to income limitations; however, the maximum contribution amount is limited to $7,000 (with an additional $1,000 catch up for those over age 50). Backdoor Roths have seen pushback from some in Congress so consider that the opportunity may be short lived. We recommend consulting your tax preparer to determine if this is an appropriate strategy for your situation.

Contribution Limits

Roth IRA contributions are limited to $7,000 (with an additional $1,000 catch-up contribution for those over age 50).

Income Thresholds

Modified adjusted gross income (MAGI) thresholds based on filing status apply, making some high-income taxpayers ineligible to contribute. Contributions are based on earned income, which does not include rental income, pensions, or deferred compensation.

Filing Status	Income Range for 2024 Contributions
Married and filing jointly	Full: Less than $230,000 / Partial: From $230,000 to less than $240,000
Married, filing a separate tax return, lived with spouse any time during the year	Full: $0 / Partial: Less than $10,000
Single, head of household, or married filing separately without living with spouse at any time during the year	Full: Less than $146,000 / Partial: From $146,000 to less than $161,000

 

Christopher Zand, J.D., CFP^®

Vice President & Director of Private Client

Natalie Belyea

Private Client Advisor