9 Facts People Don't Know About Roth IRAs

This retirement tool may be more versatile than you think

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Roth IRAs are powerful and flexible financial planning tools. They are also complex; many people aren't familiar with all aspects of Roth IRAs. Here are nine facts about Roth IRAs that may surprise you and have an impact on your retirement planning decisions.

Key Takeaways

  • There are multiple advantages to funding a Roth IRA and specific strategies that can be beneficial for retirement planning.
  • Contributions to a Roth IRA can be withdrawn at any time without penalties or tax consequences.
  • High-income earners can overcome income limits by contributing to traditional IRAs and converting to a "backdoor" Roth IRA.
  • Unlike traditional IRAs, Roth IRAs do not require distributions at a certain age.
  • You can contribute to a Roth IRA on behalf of your spouse through a spousal contribution.

Roth IRA Contributions Can Be Used as Emergency Funds

Roth contributions are not deductible. The advantage to this is that you can withdraw your contributions at any time, for any reason, and no taxes or penalties apply. With this kind of liquidity, a Roth IRA can double as your emergency fund.

Before you plan on using your Roth for this purpose, however, keep in mind that the definition of "contributions" does not include amounts converted to a Roth, nor does it include investment gains.

For example, if you put $5,500 in and it grew to $6,000, you could withdraw the $5,500 of contributions without taxes or penalties, but taxes and penalties may apply if you withdrew the $500 of gain.

Some Can Use a Non-Deductible IRA To Fund a Roth

If you make too much money, you can't contribute to a Roth IRA—or can you? Some people who have all their other retirement money inside qualified retirement accounts can make a non-deductible IRA contribution each year and then convert that to a Roth, thus annually funding their Roth IRA. This is sometimes called a "backdoor Roth."

The key to making this work without paying extra taxes is making sure you don't have other IRA accounts.

In some cases, you can even roll a self-directed IRA back into a company plan, so that in future years, you could use the backdoor Roth strategy without having to pay taxes on the converted amount.

You Can Roll After-Tax 401(k) Contributions to a Roth IRA

Many employer plans allow you to make after-tax contributions. At retirement, these after-tax contributions can be rolled directly into a Roth IRA. Any investment gain on the after-tax contributions can't go into the Roth, but the amounts you contributed can.

If your employer plan offers this feature, you can accumulate after-tax savings and later use it to fund a future Roth IRA. This is advantageous in retirement, as Roth IRA withdrawals are not taxable and do not impact other items on your tax return the way traditional IRA withdrawals do.

Roth IRAs Have No Required Minimum Distributions (RMDs)

One great thing about Roth IRAs is that, unlike traditional IRAs, there is not an age where you must begin taking money out. This means there is no delayed tax bomb waiting for you with a Roth.

Note, however, that your non-spouse heirs will have to take required distributions from the Roth, but those distributions will be tax-free to them.

You Can Contribute to a SIMPLE IRA and a Roth IRA

As long as your adjusted gross income is below the Roth IRA contribution limit, you can contribute to a Roth IRA as well as to a SIMPLE IRA, maximizing what you are saving for retirement. The contributions to the SIMPLE will be deductible, and the contributions to the Roth will not.

This dual-funding strategy gives you the ability to reduce taxable income now and have some funds in the Roth accumulate for tax-free benefits in retirement. This could be advantageous for someone who is self-employed and trying to save as much as possible for the future.

Your Employer Plan May Allow Roth Contributions

Many 401(k) plans offer the ability to make Roth contributions. This is called a "designated Roth account." Check with your employer to see if their plan provides you with the ability to choose which type of contribution you want to make.

With some plans, it has to be all Roth or all tax-deductible. Other plans allow you to do some of each. If your employer plan doesn't currently allow Roth contributions, request that they add it next time they amend their plan.

Age Is Not the Biggest Factor in Determining If You Should Fund a Roth

Conventional wisdom says the younger you are, the more time you have for money to grow tax-free inside a Roth. It's true, more time makes Roth IRAs better, but age is not the primary factor to use in determining whether to fund an IRA or a Roth IRA. The primary factor to use is your tax bracket—both your marginal tax rate now and your expected marginal rate in retirement.

If your expected tax rate in retirement is likely to be lower than your tax rate now, the deductible contributions may be better. If your tax rate in retirement is likely to be the same or higher in retirement—which is often the case for those who have large 401(k) or IRA accounts—then Roth accounts may make a lot of sense for you.

You May Be Able To Make a Spousal Roth Contribution

Even if your spouse has no earned income, as long as you have earned an income, you can make an IRA contribution on their behalf. This is called a spousal IRA contribution. Many couples can double their tax-favored retirement account savings by taking advantage of this.

Ask your accountant or financial advisor if your financials are such that you are eligible to make a spousal Roth contribution.

Roth Conversion Calculators Miss Some Things

You can convert traditional IRA or 401(k) money to a Roth. Many online retirement calculators project the results of such a transaction to help you see if it might make sense for you. However, there are many things these online Roth conversion calculators miss.

For example, they don't factor in the impact of future required IRA withdrawals and how that impacts the taxation of your Social Security. A Roth can help reduce the impact of this. When you factor everything in, in many cases, Roth conversions can be more advantageous than online calculators may lead you to believe.

Frequently Asked Questions (FAQs)

Is there a limit on how many Roth IRAs I can have?

You can open as many IRAs and across as many types as you like, but the amount you can contribute (in the aggregate) is still limited to a yearly cap by the IRS.

Should I open a Roth or traditional IRA?

The type of IRA that is best for one person may not be best for another, as each has unique traits and benefits. Generally speaking, younger people have more time for funds to grow tax-free in a Roth account. You can also consider your current income tax rate and your potential future tax rate during retirement to help you decide. Traditional IRA contributions, by comparison, are deductible, but later withdrawals are taxed as income. You'll want to choose the account with optimal tax treatment for your situation.

What should I do if I contributed too much to my Roth IRA?

The IRS sets yearly limits on Roth IRA contributions, and a 6% tax penalty applies for breaching these. In 2022, the limit is $6,000 for people under age 50, with an additional $1,000 catch-up contribution for anyone older. You are also restricted from contributing to a Roth IRA if your income exceeds $144,000. To avoid paying the penalty, you must withdraw the funds in excess of these limits by the end of the tax year.

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