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The Roth IRA is the second account in the Phippen Tax Accounts You Need Next series because it is a retirement account to which anyone with earned income (whether from employment or self-employment) can contribute and enjoy tax-free growth and tax-free withdrawals in retirement. (If you do not have earned income yourself – for example, you are a full-time student – earned income by a spouse also makes you eligible.) To refresh your memory about this account, here is why you need one:
The Roth IRA is a tax-advantaged account where you can save for retirement regardless of your status as an employee or self-employed. It also provides a consolidation point for any employer retirement accounts that you need to roll over after leaving a job. While a traditional IRA is often better in the short-term, a Roth IRA is generally the better long-term investment.
Why a Roth IRA?
Employers sponsor most retirement plans within the United States, reducing the ease and opportunities to save for retirement for individuals who are unemployed, self-employed, work part-time, or work as a contractor in a capacity where their employer does not offer full benefits. The Roth IRA is an option open to anyone: Whether you work only 10 hours each week or work 80 hours each week cobbled together between five employers who do not offer you a 401(k),* you can contribute to a Roth IRA.
Even if you have a 401(k) or other employer-sponsored plan, you can still contribute to a Roth IRA. In fact, it benefits individuals to have an IRA account of the same kind, Roth or traditional, as their 401(k) in the event they decide to leave a job and move to another. When you leave a place of employment, you can roll over retirement accounts from your employer’s plan to your own IRA (traditional or Roth) so all of your retirement investments are concentrated in one place.
We recommend rolling any 401(k)s into a self-managed IRA upon leaving a job in most cases since it can be time consuming to find and collect multiple 401(k)s upon retirement. In the interim, it also makes tracking your net worth more difficult. (If you know you have unconsolidated accounts sitting out there from old employers, contact us for assistance organizing your retirement investments.)
While you may want both a traditional IRA and a Roth IRA for consolidation purposes, investing in a Roth IRA is the ideal choice to provide yourself retirement stability. A Roth IRA, similar to a Roth 401(k), is taxed initially when the money is contributed. However, that money grows tax-free and can be withdrawn tax-free starting at age 59.5. This protects you from fluctuations in tax brackets and facilitates more accurate retirement planning.
The other reason to contribute to a Roth IRA instead of a traditional IRA is to avoid mandatory withdrawals starting at age 72 to 75 (depending on when you were born).** Your age, life expectancy, and balance in your traditional account determines your required minimum distribution each year. These withdrawals are mandated to allow the government to collect taxes on this money since traditional IRA contributions are pre-tax and grow tax-free. Required minimum distributions also aim to prevent wealthy individuals from using their IRA as an estate-planning tool instead of a retirement account. If you want to control your taxable income with less government interference in retirement – or want more control over what you leave behind after your death – opt for a Roth IRA instead of, or in addition to, a traditional IRA.
Logistics: What and Where to Contribute
IRAs, like 401(k)s, have annual contribution limits. In 2023, the contribution limit for IRAs (Roth or traditional) is $6,500 per individual. There are no household or family limits on IRAs–in fact, if your child receives income, they can even have a Roth IRA to begin investing for retirement at a young age!
Like 401(k)s again, IRAs offer catch-up contributions for individuals age 50 or older. In 2023, individuals age 50 or older can contribute an additional $1,000 to their IRAs, bringing the total contribution to $7,500. (Beginning in 2025, enhanced catch-up contributions are allowed for individuals aged 60 to 63.) Again, this is assessed on an individual basis, so if you are 51 but your spouse is 49, you can contribute $7,500 to your Roth IRA this year, but your spouse can only contribute $6,500 in 2023.
These contribution limits are for the total IRA contributions an individual makes throughout the year. This means you cannot contribute $6,500 to a Roth IRA and another $6,500 to a traditional IRA. You can only contribute $6,500 total across all IRAs in 2023.
Rolling a 401(k) into an IRA does not count towards this total. If you worked for an employer for a few years and have $250,000 in a traditional 401(k), you can roll that directly into a traditional IRA without an issue to consolidate those funds. The same is true if you are rolling a Roth 401(k) into a Roth IRA. Rolling an employer-sponsored retirement account directly into your personal IRA in no way affects the limit of your annual IRA contributions, but it does need to be indicated on your annual taxes. (If you need assistance rolling over an account and/or reporting the rollover on your taxes, we can help.)
You can open a Roth IRA with just about any investment company, but you should investigate the fee structure before deciding where to open one. We typically recommend self-directed brokerage accounts since they have fewer fees. However, only you can decide whether you are comfortable with a self-directed account rather than paying a professional financial advisor to manage your account.
Choosing an investment company with a user-friendly online platform that allows you to make transactions easily is particularly important if you choose a self-directed account. Finally, verify that any account minimums meet your needs. If you still want more specifics on choosing a financial institution, particularly if you plan to house multiple accounts in one place, Ramit Sethi’s I Will Teach You To Be Rich gets into the specifics of various institutions.
Invest Your Money!
You can only experience the tax-free growth provided by a Roth IRA if you actually invest your contributions! Every so often, we hear from someone who contributed to their Roth IRA and does not understand why they are not reaping the benefits of compound interest. This happens because the individual does not invest the money into an index fund, target retirement date fund, or other investment.
Do not overthink your investments. Picking an index fund that gives you a small share of the entire market is the simplest and most effective way to experience growth, as outlined by J.L. Collins in The Simple Path to Wealth. The Simple Path to Wealth is a great book to read if you experience any fears of investing. While you should seek financial advice for your specific situation, index funds and target retirement dates are usually the easiest way to realize compound interest immediately. However you decide to invest, make sure you do! Do not miss out on years of compound interest due to overthinking your options or general apathy!
Backdoor Roth
While there are no specific employment requirements to open a Roth IRA, there are income restrictions. The contribution limits vary according to your filing status and income level. Ultimately, if your income is too high, you are not eligible. But there are workarounds.
Here are the restrictions that may affect you if your income level is too high:
You cannot contribute to a Roth IRA.
You will not receive any tax breaks from a traditional IRA.
Here is how you get around those restrictions: You can still contribute to a traditional IRA, even if you do not realize the tax benefits of a deduction for your contributions. Why contribute if there are no tax benefits? If your income is too high, the only change is that a one-step process becomes a two-step process: Instead of contributing directly to a Roth IRA, you first contribute to a traditional IRA and then convert those funds to a Roth IRA.*** (The specific “how-to” will vary by financial institution.)
You have to love those tax loopholes!
*We use “401(k)” to discuss factors that are true for various types of employer-sponsored retirement accounts. In any case where there are differences, they are specified. The specific type of account available to you is based on your employer type. For example, only federal government employees can participate in the Thrift Savings Plan.
**Before January 2020, mandatory withdrawals began at age 70.5. More recently, as part of the SECURE 2.0 Act contained within the omnibus spending bill passed by Congress in the waning days of 2022, the “RMD age” increased to 73 beginning in 2023, and will increase again to 75 beginning in 2033. These changes emphasize the unpredictability of leaving the majority of your money in a traditional account: If you want to choose when and how much to withdraw without legislation requiring changes in your plan, contribute at least some of your money to a Roth account.
***When you convert a traditional IRA to a Roth IRA, you pay taxes on the amount converted since you funded your traditional IRA with pre-tax money. (There is no early withdrawal penalty because the balance remains in an IRA.) If all your contributions were nondeductible, you will only pay taxes on the growth between the time of the contribution and conversion.
About the Financial Accounts Series: The Financial Accounts Series is a four-part series discussing financial accounts that can improve the health of your finances. The Phippen Tax & Financial Services team will provide a deep dive on each of the accounts listed in Part 2, Accounts You Need Next, before releasing Part 3, Accounts You Want. If you missed Part 1, Accounts You Need First, start there! If you would like to seek additional guidance about your personal finances or the specific organization and composition of your financial accounts, please contact Patrick Phippen or complete a new client form if you have not worked with Patrick in the past.
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