Everything You Need to Know About Roth IRAs

Key Takeaways

• The headline advantage of having your money in a Roth IRA is that you’re able to enjoy tax-free compounding on your money.
• The biggest drawback of Roth IRAs is that you will not earn that tax break on your contribution.
• For 2023, we see some nice increases in terms of contribution limits, the first we’ve seen in a few years. We’re going up to $6,500 for people who are under the age of 50 and $7,500 for people who are over 50.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Investors have questions about Roth IRAs, and Morningstar’s director of personal finance, Christine Benz, has the answers. She is here with me today to discuss what investors need to know about Roth IRAs.

The Benefits and Drawbacks of a Roth IRA

Dziubinski: So, Christine, let’s start out by talking about some of the key advantages of making Roth IRA contributions versus putting everything in a traditional tax-deferred IRA.

Christine Benz: Sure. So, the headline advantage is that if you have money in a Roth IRA, you’re able to enjoy tax-free compounding on your money. So, as long as the money is within the confines of the Roth IRA, no taxes will be due on the account. And then, even more advantageous is that, in retirement, you will not owe any taxes on your withdrawals. So, those are tax-free withdrawals in retirement. In contrast, the deal with traditional tax-deferred IRAs is exactly the opposite. So, you will enjoy a tax break on your contributions. You’ll get a deduction if your income falls below certain thresholds, but you’ll owe the full freight in terms of income taxes when you pull the money out in retirement. And then, a secondary advantage to Roth IRAs in addition to that tax treatment is that you aren’t subject to required minimum distributions on that account once you hit age 73. So, you’re able to just keep the money in the account if you choose to do so. You’re not subject to those required minimum distributions, which traditional IRA investors are subject to, and of course, those are taxable as well.

Dziubinski: What are the potential drawbacks or trade-offs that come with making Roth contributions?

Benz: The biggie is that you will not earn that tax break on your contribution. So, it’s not a tax-deductible contribution, and there may be knock-on effects. If you make a tax-deductible IRA contribution, for example, you may qualify for certain tax credits. If you make Roth IRA contributions, those tax credits might be off the table. So, that’s the big drawback to making Roth IRA contributions is that you won’t earn that tax break in the here and now.

Dziubinski: Christine, one question that often comes up about Roth IRA withdrawals is: Will the government change its mind and start taxing Roth withdrawals? Is that a legitimate concern in your opinion?

Benz: It comes up a lot, Susan, I will say. But one point I would make—and this is just my opinion—but the Roth IRA and IRAs in general are pretty prescribed in terms of how much you can get into the account, the income limits that pertain to IRAs, all sort of constrain its utility to those of us who are middle- or maybe upper middle-income taxpayers. These are the people who are really excited about making Roth IRA contributions. So, the idea that Congress, I think, would jeopardize the benefits of Roth IRAs for that very broad group of taxpayers, I think, is pretty unlikely, that Congress would change the rules regarding Roth IRA distributions.

Dziubinski: How can investors figure out whether they’re better off making a Roth IRA contribution or a traditional IRA contribution, assuming that they’re eligible to make either type of contribution?

Benz: It’s a crucial question. And the name of the game is thinking about whether the tax break is more valuable to you at the time of the contribution—so is your tax rate going to be higher at the time of the contribution than it will be at the time of withdrawal? And in that case, traditional tax-deferred contribution will tend to make the most sense. So, a great example here would be older workers, for example, who haven’t yet saved that much, still working, maybe their incomes are at a high point, and they expect that their income level will drop down in retirement. They might be a good candidate, assuming their income falls below the thresholds to make a traditional tax-deferred contribution.

On the flip side, say you have some young investor, maybe someone in his or her 20s or 30s just starting out in a career, expecting to see earnings really accelerate, so their tax bracket’s at a fairly low level, their earnings aren’t very high yet. They are a great candidate for making Roth contributions because their tax rate in retirement may well be higher than it is at the time of the contribution. And then, you might also want to bear in mind tax rates secularly. So, when I talk to tax experts, what you sometimes hear is that tax rates are at a pretty low level today for all of us across the spectrum. And so, it is not a terrible idea to think about locking in paying the taxes due on the contribution at the time of the contribution, as is the case with Roth IRAs, in exchange for being able to take those tax-free withdrawals later on when tax rates, broadly speaking, may in fact be higher.

Roth IRA Contribution Limits 2023

Dziubinski: Now, Christine, there are contribution and income limits when it comes to Roth IRAs. What are those?

Benz: Right. So, for 2023, we see some nice increases in terms of contribution limits, the first we’ve seen in a few years. So, we’re going up to $6,500 for people who are under age 50 in 2023 and $7,500 for people who are over 50. So, you get to make a little bit of a catch-up contribution if you’re over 50. And then, we’re also seeing a nice boost in terms of income limits. So, for 2023, the income limits for single filers are $153,000 and $228,000 for married couples filing jointly. If you’re over those thresholds, you cannot make a direct Roth IRA contribution.

Dziubinski: On a related note, Christine, let’s talk a little bit about the backdoor Roth IRA. Now, this is a way that some investors can get around those contribution limits that come with Roth IRAs. How does that backdoor Roth IRA maneuver work, and who should consider it?

Benz: Sure. So, first question, who it might work for? If your earnings are over the thresholds that I just discussed and you still want to get money in a Roth IRA, this is something to consider. So, the basic idea with this backdoor Roth IRA strategy is that you make a contribution to what’s called a nondeductible traditional IRA. And there aren’t any income limits that apply to it because you can’t deduct that contribution on your tax return. So, you make that contribution to the traditional IRA and then shortly thereafter—and tax experts differ a little bit in how long you should leave the money in the traditional IRA, but I don’t think you have to leave it too long—shortly thereafter you can convert that traditional IRA to a Roth IRA. So, there aren’t any income limits that apply to conversions either.

It’s a pretty easy thing to undertake. I like the idea of people who are over those income thresholds, just doing it routinely every year, getting the funds into the traditional IRA, then doing those conversions. One thing to keep in mind, though, is that you need to be careful about the tax implications of that conversion. So, there’s what’s called the pro rata rule that relates to your total IRA accounts’ proportion of monies that have never been taxed relative to funds that have already been taxed. So, if you have a lot of, say, traditional rollover IRA assets, for example, consisting of funds that have never been taxed, you may owe a little bit of a tax bill when you do that conversion on your backdoor Roth contribution. So, just bear that in mind, maybe get some tax advice before undertaking that backdoor maneuver.

Roth IRA Tips for Retirees

Dziubinski: And then, lastly, Christine, let’s talk a little bit specifically about those investors who are near retirement or already in retirement. What should they know about those Roth IRA accounts?

Benz: One thing to keep in mind is what’s called the five-year rule, which might affect whether your IRA distribution, your Roth IRA distribution, is indeed tax-free. So, check up on that. Make sure that you understand the five-year rule if you’re making contributions and conversions close to retirement. And then, another important consideration is what is sometimes called the sequence of withdrawals that you should use among your various retirement accounts when you’re actually in retirement, which account should you look to to fund those first withdrawals, which accounts should you hold on to tap for later. And the key thing to know about Roth IRAs is that they are gold from the standpoint of your retirement distributions, because they’re not taxable. So, generally speaking, you want to hold on to them as long as you possibly can. They’re also beautiful assets for heirs to inherit because they don’t have that tax bill attached to them. So, again, get some tax advice, but generally speaking, these are your most valuable assets from a tax standpoint, so you want to hang on to them as long as you possibly can.

Dziubinski: Christine, thank you for your time today. Investors have a lot of questions about Roth IRAs in particular, and hopefully, you’ve answered a lot of them today. We appreciate your time.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch “Retirement Income and Safe Withdrawal Rates in 2023″ for more from Christine Benz.