Episode 83: Roth IRA Basics: Maximizing Retirement and Tax Benefits
In episode 83 of Accessible Finance for Retirement, hosts Eric and Rachael Johns uncover the essentials of Roth IRAs and the value they bring to your retirement strategy. From understanding the foundational details to exploring how Roth accounts can offer lifetime tax benefits, we've got you covered. Join us as we navigate these financial waters and learn how to optimize your retirement planning. Secure your future by mastering these key insights. Listen now to grasp the full potential of Roth IRAs!
🎙️ Have a financial scenario you’d like us to discuss (without giving personalized advice)? Send your questions to podcast@equilibriumfp.com—we’ll keep your information completely anonymous!
📢 Don’t forget to like, subscribe, and share with friends who could benefit from smarter retirement planning tips!
Read the Transcript
Episode 83
Eric: Welcome to episode 83 of Accessible Finance for Retirement. You noticed two extra words at the end there. Mm-hmm. Um, because we want to better reflect the conversations that we're having on the show, and that's largely attributable to the tax complexity that makes them more interesting to have.
Rachael: Absolutely. Um, so to that end, we are starting a three part mini series that are focused on Roths. Um, today's episode is on Roth Fundamentals, um, and they'll get progressively more, um, detailed and in depth as we go through the miniseries. I'm excited. Sound good? Alright, very much. Um, so before we dive in, um, let's briefly talk about where the Roth accounts came from.
Um, they've been. Taboo for quite some time, but they've become a lot more mainstream. Um, they weren't created until 1997 and Eric, you know, were they initially Yes. It was
Eric: a congressman that wanted to use the rules? No, I don't know.
Rachael: Yeah, yeah, yeah. Yeah. Senator, Senator William Roth of Delaware sponsored the legislation.
Um. Okay, so let's start out with the Roth IRA Basics.
Eric: Okay.
Rachael: It is the most common type of Roth account. So let's start out by comparing it to a traditional IRA and what those key differences are.
Eric: Got it. So traditional IRA means you're paying with pre-tax dollars, which means you're not going to pay federal income tax yet, or state income tax.
Mm-hmm. On those dollars when you deposit those dollars into the account, right? Mm-hmm. So that typically looks like deferring. Salary into your 401k, you will pay the FICA taxes, which refers to the Social security and Medicare component, however, also called payroll taxes, or you'll hear self-employment taxes.
That's all separate and apart from income taxes, federal and state. So you're gonna deposit or defer those taxes, you're deferring taxation on them into your account, and then you pay ordinary income tax when you withdraw the funds later in life from the account and potentially penalties if you don't follow the rules.
Okay.
Rachael: That will be a running theme here. Yes. Penalties and interest if you don't follow the rules. Correct. Um, okay. So with a traditional IRA, you get the tax deduction on the front end, on the
Eric: front, and then everything that's pulled out, regardless of the character of the investments within the account.
Is going to be taxed at ordinary income rates instead of, what I mean by that is you could potentially, and very likely should, if you're, you know, a young person, have large amounts of equities, if not entirely equities in your 401k, right when you start. Mm-hmm. Okay. So that's a tax deferred account has a ton of equity.
So some people think, hey. Long, long term. I held this for over a year. Yeah. Why is this not taxed at a 15% long-term capital gain rate? Assuming I'm in that bracket, or 0% or 20%?
Rachael: I'm sure that everyone is thinking that
Eric: actually they, they very well could be. Right.
Rachael: So people who are informed enough about, I mean, I would say the majority of people that we interact with, um, tend to have their eyes glaze over when we start talking taxes.
Eric: It's so much fun though. There's so much opportunity.
Rachael: But for those that are. More comfortable being in the weeds or more familiar with the different types of taxation.
Eric: Mm-hmm.
Rachael: It would be reasonable for them to think, okay, if I've had long-term equities
Eric: Yeah.
Rachael: That's gonna be taxed at long-term capital gains.
Eric: Right. The thought is that maybe I'd be able to pick between the more favorable tax rates. Right. And capital gains will always be more favorable than ordinary income. Mm-hmm. Given your brackets. Right. So the idea is that regardless of the character of the gains or appreciation of these assets. Within the tax deferred accounts, when you take them out, you're taxed at ordinary income at both a state and federal level.
Rachael: Mm-hmm. That's a good point.
Eric: So that's important. Um, the Roth account, however, is the inverse. So I pay all the federal and state income taxes on the front end. Mm-hmm. And then when I take the money out, it avoids that completely provided it is a qualified withdrawal.
Rachael: Right. So again. You have to follow the rules for withdrawals for both accounts.
Eric: Mm-hmm.
Rachael: Um, but the significant difference is the tax treatment of the funds as far as when it is taxed. Correct. Um, okay. Beautiful. So let's discuss there are contribution limits Yes. Right. Um, for the Roth.
Eric: Correct.
Rachael: Um, and you know, something Eric really likes to say is that, um, the reason for. The limits is because the account is so very favorable.
Eric: Correct.
Rachael: Um, and so very, very important to be mindful of what the limitations are. What the rules are, um, and to participate in the years that it is advantageous for you.
Eric: Correct. So in this episode we're just talking about direct contributions.
Rachael: Yes.
Eric: And so there are income limits. So like when you make above a certain amount of income mm-hmm.
You are supposed to be. Disallowed or prohibited. Correct. From making direct contributions to your Roth I rra and in fact you are. You can no longer make direct contributions. However, there are ways around it Yes. That we'll discuss in the next episode called Roth conversions.
Rachael: Yes, yes, yes, yes. And you've also heard Eric discuss Backdoor Roth previous episodes as well.
You've heard,
Eric: which is simp simply an annual Roth conversion.
Rachael: Yeah. So that is, like we said, we set that aside though
Eric: for now. And we will say though, that it's coming when you're trying to just make the most. Straightforward contribution to your Roth account? Mm-hmm. Which, well, logistically that just looks like some people will say like, wait, what does that mean?
Yeah, yeah. Like how do I do that? Right. You can just have a taxable brokerage at, say, Schwab, Vanguard, fidelity, one of the low cost brokerage. You mean you can have it anywhere, but that's where we would suggest, typically, yeah, have it at a low cost brokerage and then you will just go to the move money.
Yeah, well you'll create your Roth IRA account. Mm-hmm. And then you can just go to usually move money from one account to the other account. Mm-hmm. Your taxable brokerage to your Roth. And they'll typically ask you, Hey, what is this? It'll say like, is this a 2025 contribution? And then if you were between, you know, uh, January and April of next year, 'cause you have until the unextended filing debt, uh, tax filing deadline, right.
Of your personal return. So typically April 15, April 15th, April 16th, somewhere in that ballpark. Um. You'll be able to make it for the previous tax. Mm-hmm. Does that make sense? So, uh, in April, 2026, I could still make a contribution, uh, for 2 25 in early April, 2020. Early April, 2026 for March For sure.
We're good, right? Sure. But the idea is that logistically all you're doing is you're logging into your account and you're just transferring money.
Rachael: Mm-hmm. Mm-hmm. And then once that money is transferred into the Roth account. It's not suddenly like doing magical things.
Eric: Mm-hmm.
Rachael: Um, one thing that we've definitely had to clarify for many people mm-hmm.
Is that the Roth account is simply an umbrella account that specifies the type of taxation. It's not in and of itself an investment.
Eric: Right.
Rachael: So there are still investment options that you would choose and typically we advise the. Highest return. Right. Highest risk, expected return. Yeah.
Eric: Highest expected return.
Highest risk In terms of like standard deviation. Mm-hmm. However you wanna measure that, right? Well, not however you wanna measure that. Typically in standard deviation.
Rachael: Yeah, true, true Or beta,
Eric: right?
Rachael: Yes. Um, but precisely so setting up the Roth account itself is very simple. Transferring the money into that is very simple.
So then you're left with needing to know what the limitations are on how much money you can actually transfer. Into that account as a contribution.
Eric: Yeah. Just so you guys know, the ballpark phase outs individual, we're talking about 150,000. Mm-hmm. That's when the phase out would start to kick in. If you're a single person and you are modified, adjusted gross for Roth purposes is 150,000.
Mm-hmm. Then you're gonna have to start thinking about, you know, another strategy to get money into the Roth. Right. Again, we'll talk about that later if you're married, finally jointly it starts at 236,000. This is in 2025. Mm-hmm. So that's what you're talking, and then when we talk about limits for the contribution.
Yeah. In 2025, it's $7,000 per person. And again, retirement accounts or IRAs in this case are individual. Yeah. So there is no joint IRA, even though Rachel and I make contributions every year. Correct. It has to be $7,000 per individual.
Rachael: Yeah.
Eric: Right. So it can be $14,000 per married, married couple, but it's 7,000 each.
Rachael: Yeah. Into each account.
Eric: And then the only other re the only the other restriction on your contributions is that you have to have earned income. Earned income to substantiate that earned,
Rachael: correct. So if I was to only earn $6,000 in a year. Right then I couldn't contribute 7,000 that year. Correct. I'd be capped at 6,000 'cause that's what I earned.
Eric: Correct. If you're single, if you're married, filing jointly, then you can use both spouses income to substantiate your contributions or earned income.
Rachael: Yes. Perfect. Thank you for the clarification. Um, so yes, so the tax free growth in a Roth IRA is a strategic planning tool to. Try to ensure that you are lowering your lifetime taxes paid.
Um, so Eric, what situation would you advocate contributing to a Roth versus a traditional?
Eric: Typically, you'll want to contribute to a Roth in years where you believe your earnings. Are less, well, it really doesn't have to be earnings. It's not limited to just earnings. It could be something like taking money out of a inherited IRA.
Mm-hmm. For example. Mm-hmm. Things that are going to increase your taxable income. So when your taxable income is artificially low or expected to be lower today mm-hmm. In the present year. Then in the future, that's when you'd want to choose a Roth. Mm-hmm. Right. That's when you wanna choose a Roth. All else equal.
There are other strategies. Right. Like leaving more money to your children, your descendants. Mm-hmm. Or you want to actually do some math there and, and think, or some thought and some math. You wanna think about their tax brackets, right? So if I, even if my tax bracket is let's say 24%, maybe even 35%, yeah.
If my kids are in the, you know, 37 plus percent tax bracket 'cause they're both doctors and lawyers or, or lawyers or you know, hiring professionals,
Rachael: hiring,
Eric: then I may actually still wanna pay a 35 Alternatively. Um, if I'm brushing up against the lifetime annual exclusion, which would be a great problem to have 'cause it's 15 million a person now.
Um, but if I'm somehow brushing up against that and I, and I'm trying to figure out how to handle this, I wanna go pay more taxes so that my estate total is actually lowering. I can pass more within a Roth shell so that they don't have to pay the tax month. They get it
Rachael: correct.
Eric: Which is a little bit more, I, we didn't need to grant dump into the granularity estate plan.
It's a bit,
Rachael: but yeah, I think that. In general, right. You're talking about contributing to a Roth in years where your income or your tax bracket is Yes. Lower.
Eric: The expectation is that it's lower than in the future, right? Correct. So yeah, so typically you're legislation young professionals for sure,
Rachael: right?
Where your income or your earning potential is just gonna continue to raise. Certainly, um. Okay, so we had discussed earlier, Eric, how, um, you know, the Roth accounts itself were kind of a taboo thing. Um, in the late nineties for sure. Early two thousands, they've become a lot more mainstream, um, especially like our generation is very familiar with it, and now workplaces are starting to even offer.
Like Roth 401k options.
Mm-hmm.
Um, so let's talk about, um, some of the differences. Sometimes when you see the word Roth or hear the word Roth, you just think everything's the same, right? Like Roth conversions. Roth contributions, Roth 401k.
Eric: Okay?
Rachael: Um, and so it can get really, really confusing. To differentiate between all of these things, right?
Sure, sure, sure. So we talked today about con contributions. We'll be talking about conversions in a later episode.
Eric: Mm-hmm.
Rachael: Um, we talked about the Roth IRA, right? Sure. But like, so that's you on your own. So let's discuss briefly the Roth 401k option.
Eric: Okay. Roth 4 0 1 Ks are. Usually present at your workplace?
Well, they're gonna have to be present at your workplace, right? It's a four. That's where it's going. It's a type of 401k. Yes. Not all. My point was not all employers will offer the Roth 401k option, correct? Correct. Who's considered like a more complicated option for your TPA or third party administrator?
Sorry, on the plan? It just makes their life a little harder. The people that are administering the 401k plan, correct? Correct. So the idea is though that the Roth 401k option functions almost identically to the 401k option. Typically the investment. Um, offerings. Yeah. Offerings are the same, right? It's the only difference is you're going to be paying the tax on the money that you're deferring.
And what I mean by that is you're always going to pay the FICA taxes, whether it's Roth or traditional IRA deferrals, correct? Right. But now I'm going to also pay state and federal income taxes. Okay. So,
Rachael: so the money I'm deferring is gonna show up on my W2.
Eric: Exactly correct.
Rachael: Yeah,
Eric: exactly. Correct. Um,
Rachael: so typically right, you'll see, or you'll get your W2, if you're contributing to a traditional, um, like a regular 401k mm-hmm.
You'll see that it essentially lowers the amount of income that's reported on your W2. Yeah. You'll notice
Eric: that your gross wages are reduced by the amount that you. Contributed, correct. All your pre-tax deductions. Yeah. Which are typically going to be 401k deferrals. Mm-hmm. And then you'll notice, you'll see like your Medicare earnings, and then you'll see that being the, the total number of your, your actual earnings.
Right. Because you're paying Medicare, remember we're paying Medicare and social security tax
Rachael: regardless
Eric: on all of these. Yes. On every go, regardless. Right? Because that's considered FICA or payroll taxes. Mm-hmm. So you're paying that still, but you're gonna avoid the income tax component.
Rachael: So if you've ever looked at your W2 and you've seen that like boxes one and two and three, like they're slightly different numbers.
That's why, that's why.
Eric: Exactly. Mm-hmm. So, um, the, the contribution limits for Roth and traditional, um, 401k deferrals are going to be the same for the employee. So it's 23,500, and then there's a catch up provision, uh, if you're 50 50 or older, and that's 7,500, so an additional 7,500. So you can get to 31,000 of deferrals.
Rachael: But if you're talking, you can also split that if you
Eric: wanted to. You could go half traditional, half Roth, that's, yeah, in a number. That's good point. You know, you can slice it however you want,
Rachael: but. The most interesting thing or the, the first thing that I hold onto when we're discussing that is that what do you hold onto?
I do hold. Thanks. Um, is that like with the typical with a Roth IRA right? You're, the majority of people are capped at 7,000. Right. Um, and we know that while that's a great start, it's not alone enough to really sustain retirement. Um, sure. But then if I could get up to like 23,000 or potentially even like 31.
Mm-hmm. I am tripling, quadrupling. Sure. You know what I can do in a contribution. So
Eric: yeah, there's a lot more.
Rachael: We've done previous power there. Correct. And we've done previous episodes about, or a previous episode about being able to kind of quantify a full package for a job that is something beyond, you know, your paycheck.
Um, and so if this is something that you. Value and are interested in having a workplace that offers a Roth 401k option.
Eric: Certainly helpful. Yeah. Yeah.
Rachael: Yeah, yeah. Yeah.
Eric: Optionality is always great for sure. That's a good one to have. Um, one more thing real quick, the catch up contribution on the Roth, I'm, I'm reasonably certain that we said it, but if we didn't, it's $7,000 and then if you're 50 or older, you get an extra thousand, so then it's $8,000.
Is your annual limit on your direct contributions, does that make sense to a Roth or traditional IRA? Mm-hmm. And then the 4 0 1 Ks have their 23 5 and then 31.
Rachael: Perfect. Um, excellent. So then the, um, so the Roth 401k essentially raises the, uh, limitation on, or the cap on how much money you can contribute or defer in this case.
Eric: Mm-hmm.
Rachael: The second thing, um, that I find interesting is the difference in the income limits as well, right.
Eric: For,
Rachael: uh, 401k versus the IRA.
Eric: Oh, they just don't exist.
Rachael: Exactly.
Eric: Um, for the four oh K.
Rachael: Correct. So we discussed that, um, that people who typically are gonna wanna take advantage of a Roth option are people who are in lower tax brackets.
Mm-hmm. So once you start. Going beyond those income limits, it may no longer be advantageous to you, but with a 401k, you have the option of being able to determine that yourself rather than the government saying
Eric: you're, you know, some people have very strong views about taxation and when they wanna pay it and you know, yeah, I'll pay all my taxes now so that I don't have to later Don't, don't worry about it.
The bandaid off. Yeah, exactly. I don't have to worry about taxes and retirement. You know, that's, that's all, that's fine. Yeah. Right. So you can do that with the uh, 401k option.
Rachael: Correct. Alright, so we're gonna move on to the third section of, um, our conversation today, which, if you are familiar or have read up on the Roth, um, accounts at all, you may have.
Heard about something called the five year rule. And so that is what I want you to explain to us right now, Eric.
Eric: Okay. So there's two, um, there are two. The first five year rule has to do with the account op, the length that the account has been open. Mm-hmm. Right? So you have to have your Roth IRA, open for five years before your earnings can be taken.
Wow. Before try again. One day I'll be able to speak, try again before your earnings can be withdrawn. Mm-hmm. Tax and penalty free. Does that make sense? So you need to have the account in existence. Okay. So it's
Rachael: 2025 right now. I open my Roth account today. Mm-hmm. Um, next year, uh, let's say I contr, this is actually an interesting scenario.
Okay. Uhoh open my, no, I open my Roth account today. Okay. Um, I put in $5,000.
Eric: Got it.
Rachael: I next year. My hot water heater breaks or my air conditioning breaks. Okay. I don't have funds to pull from anywhere else. I'm gonna, unfortunately we would never advocate this, but I'm gonna unfortunately have to pull from my Roth.
Eric: I'd be very sad. Yes. Um,
Rachael: my Roth account is now 7,000. It's gone from five to seven. Um, I need, I don't know, 6,000 for my ac Sure. Right. The 5,000 that I pull out, which was my original contribution. What is the tax treatment on that?
Eric: Contributions are always tax and penalty free.
Rachael: Beautiful. So if you're on the fence about a Roth or about your time horizon or anything like that, your contributions, you can withdraw.
Tax and penalty free. Tax free inside the five year rule?
Eric: Yes. Apart, separate. Apart from five year rules. Perfect. Any other thing that you might be thinking about now?
Rachael: I said I need an extra thousand dollars, which is coming from the earnings. My account has not been in existence for five years.
Eric: Correct. Um, the earnings will come out and you will pay taxes.
And a 10% penalty, assuming that it's not a qualified withdrawal, we're not over 59 and a half. In that case, you'd still, I believe, pay taxes but not the penalty. Mm-hmm. Could be wrong there actually. Um, yeah, they, this is a really, specific rules are incredibly complicated.
Rachael: Correct. Like there are little caveats for different, um, ages and life situations.
Sometimes they'll allow you to take out a certain. Amount of money for certain life, um, events that are qualified, it's incredibly punishing. You're outta of five years
Eric: and, and it's non-qualified, you're almost certainly paying taxes and Yeah. 10% penalty, correct? That's the answer.
Rachael: So in order to be outside of the five year rule, correct.
My account needs to be in existence for five years. So let's say I opened the account in 2025 and I put in a hundred dollars.
Eric: Okay.
Rachael: Okay. Then in 2029. I contribute 5,000.
Eric: Okay.
Rachael: Right. In 2030. Um, it's grown in 2030. The account's been open for five years. Mm-hmm. But I didn't make that large contribution until last year.
Eric: Still fine. You can withdraw everything. Tax has the has for existence for five years, assuming that it's a qualified withdrawal again. Correct? Correct. And qualify withdrawal. The most common is you're over 59 and a half. Okay. That's the most common. But then there are others like death and disability. I think it's like $10,000 for the purchase of your first home.
Yeah. There are a number of rules. There's something
Rachael: for education. Yeah. They
Eric: differ slightly between traditional IRAs and Roth IRAs. Mm-hmm. So, I mean, you, you can, a quick Google will give you that, that list and most of the, you know, you won't have to hopefully encounter very much
Rachael: and. They're also, they have capped amounts, so it's not like, oh, I can just pull out my whole Roth.
So de definitely know the rules. I will say, and we know this from experience with, um, people that we know, um, if you are to withdrawal funds incorrectly.
Eric: Yeah, there's no, you can't really un undo it anymore. It used to be able to recharacterize and, and kind of mess with the, the Roth and the Roth conversions. Now, when you've done that, you cannot,
Rachael: it's really unforgiving before the
Eric: end of the tax deadline, you can recharacterize Roth contributions as traditional contributions or non-deductible.
IRA contributions. There are things you can do there if you've realized like, oh wait, I contributed and I shouldn't have. Right? You could do for, like, for example,
Rachael: I didn't make. $7,000. Right. But I contributed $7,000. Right. And you have to have earned the amount of income. So if you contribute 7,000, but you only earned 6,000 right before the tax filing deadline, you can take that extra thousand and change.
Eric: Right.
Rachael: The categorization.
Eric: Yeah. And you can usually work with your custodian and they'll help you out there. Mm-hmm. But for withdrawals, right. So we talked about five year rules. So the first one is the account has to be open for five years. Okay. There's a separate five year rule on Roth conversions.
Mm-hmm. Right? So the amount of the converted funds needs to be in the Roth account for five years before you can withdraw the conver, the converted amount, tax and penalty free. Right. So remember contributions we said, which is just you putting the money straight into your account from like your taxable account to your Roth.
Mm-hmm. Right? That's a contribution. That's a direct contribution. You can withdraw that at any time, tax and penalty free. Mm-hmm. The second. Is a Roth conversion, which means you've, you have some amount of dollars in a tax deferred account, typically a traditional ira mm-hmm. Of some sort. Right. And or you know, it can be a rollover IRA, but it's gonna have a tax deferred status.
Right. So typically you're gonna, you're, well, not typically you're going to convert those funds. That's a Roth conversion. Mm-hmm. Okay. When you convert from a traditional IRA into a Roth IRA, and at that point you pay the taxes on all of the funds. Correct. Okay. So you're not gonna have to pay taxes again.
On the funds that you've converted. However, if I withdraw those funds, so say I convert $5,000, right, and then I immediately withdraw my $5,000 from my Roth, I have to pay a 10% penalty or $500. Off of on the 5,000 for just ripping them out immediately. Yeah. 'cause I didn't wait five years. I just immediately pulled it out.
Yeah. So every conversion has its own five year clock timer on the actual converted fund limit. Does that make sense? And this
Rachael: is where it gets confusing. 'cause you're talking contribution conversion. Right? They sound similar. They both have to do with Roths. They both start with C. They do. It's very. Very confusing.
Yeah. So today's episode, what we have been talking about with the 7,000 um, dollar limit and all of that, that is a contribution. Correct. Which upon contributing, you can then withdraw the contribution itself. Yes. Tax and penalty free. Yes. The conversions, which we're gonna talk in detail about in our next episode, has the slew of rules like Eric was saying, where.
Each contribution. So like I, each
Eric: conversion,
Rachael: I mean, sorry. Thank you.
Eric: It's,
Rachael: see, yes, it's each conversion, it's confusing. So if I do a Roth conversion in 2025, that conversion I cannot pull out without paying penalties till 2030, right? Correct. But then next year, in 2026, I'm gonna do a conversion. That one I cannot, cannot pull out in 2030.
It has a separate timer.
Eric: Correct.
Rachael: So 2031. So for the contributions. It's the timers on the account itself for the conversions, the timers on each conversion.
Eric: That's exactly right. Yeah. And then just one more thing to reiterate. Contributions, direct contributions. Always forget all the five year clocks. You can pull those out.
Tax and penalty free. Yeah. So if I've aggregated, you know, contributed directly, contributed $40,000 to my Roth over a number of years, maybe my Roth value is a hundred thousand. Okay. So I contributed 40,000 current value a hundred thousand. Mm-hmm. I can always pull 40,000 out of my raw. Correct. And I don't have to worry about it.
Right? Yes. I just need to know what my basis or what I've contributed, right. What my basis is. And
Rachael: this is where theoretically, right, like the. System, the banking system that you're using should have records, however, right? It is.
Eric: Make sure you track it. Yeah. It's best practice so that if you get audited you can say, Hey, look, here it is, this is
Rachael: what happened.
It's best practice to keep detailed records of your contributions, your conversions, their dates. Um, you can even like look online for like a Roth tracker. They have all sorts of them out there. Mm-hmm. But keeping your own records is gonna be better than.
Eric: The only other trying to rely on, the only other point I'd like to make on the conversions, um, and contributions.
Mm-hmm. I know it's, it's tedious, it's cumbersome. There's also an ordering rule, so mm-hmm. If I have, you know, like people will say, wait, well, well I did a conversion and I also contributed some dollars, and then I have earnings.
Rachael: Yes.
Eric: What if I pull a thousand dollars out? How does anybody know what that is?
Which is mm-hmm. So there's ordering rules for the withdrawals from Roth IRAs. Mm-hmm. And those rules are. The first money that you take out will always be contributions. So my direct, everything that I take out is treated as a direct contribution until I've used all of my contributions mount up. And then it's all of the conversions.
Conversions, yeah. Okay. And then it's earnings on contributions and then earnings on convergence. However, the earnings are essentially gonna be the same
Rachael: it, but in all honesty, it ends up going from like the least restrictive to the most restrictive, like withdrawals essentially. Right. So on your.
Contributions, right? You can at any point draw those, withdraw them
Eric: tax penalty free, like tax and penalty
Rachael: free. Mm-hmm. So it makes sense that those would be the first dollars. But if you don't have records that indicate to you how much money you have in contributions, you don't know at what point you're switching over into your conversions and then.
Making sure that you have funds that have been in there for at least five years, because you might get hit with a surprise penalty bill. That's never fun.
Eric: Yeah. The only other thing, it's. It's kind of, it's somewhat complicated. There's, I don't, there's a lot need to add another rule or another rule.
There's a lot, there's a lot to know. If you're over age 59 and a half
Rachael: mm-hmm.
Eric: And you make a Roth conversion to an account that's already been in existence for five years, you can pull that out immediately. Tax free tax and penalty free. Does that make sense?
Rachael: Because of your age?
Eric: Correct. Because you're, it's already considered qualified.
You're already over 59 and a half. Um, and you're, you've already paid the ordinary income tax at the point in time you converted it. Yeah. So they were not gonna make you wait five years on each conversion when you're over 59 and a half.
Rachael: Correct.
Eric: Even if you're, you know, yes. Right. When you're 59 and a half, that five year rule vanishes, you're only worried about, I'm sorry, the five year rule on the conversions Yes.
Kind of vanishes, right.
Rachael: The five year rule on the account. But the five year
Eric: rule on the account, yes. Still very much applies
Rachael: and again. This is why we're discussing this and this episode is kind of the basics of it. There's a lot to know. And so when you're talking about the five year rule, there's two rules and both of them are five years.
There's conversions and there's contributions, and then there's different treatments on the earnings. And there's, there's so much to know that, um, you know, typically you'll. Find people who just don't want to even bother with it. Right? 'cause it's so complicated and can be so punishing if done incorrectly.
Eric: Right. Before we get to the q and a section, just to distill this into what we're talking about, right? Mm-hmm. Like just. What is my takeaway? If you had one thing to say? Yeah. Roth conversions are very, very fantastic planning tools. Mm-hmm. They're great accounts. You want dollars in Roths more than anything else.
Mm-hmm. Because they grow tax free forever. Right. So if you're thinking about retirement, broadly speaking, we're always going to have withdrawals after 59 and a half, or for the vast majority of the time. Mm-hmm. Even if we're planning on retiring early, we can take contributions out tax and penalty free.
Mm-hmm. So even if we're retiring early, we could pull that money. But just to distill it. Roth IRAs fantastic tool. You want to use them if you think your earnings now or your taxable income now. Is less than it will be in the future. And what I mean by that is taxable income to put you in a bracket. Does that make sense?
Like we're really concerned with the effective tax rate and the marginal effective tax rate that we always like to talk about. Yeah. Um, we're just interested in your, kind of, your marginal bracket plus all that. That's a fancy way of saying we're interested in your marginal tax bracket plus all of the.
You know, penalties or credits that you could either gain or lose. Mm-hmm. Does that make sense? The additional, I shouldn't say penalties. Additional taxations like net investment income tax, you know, your Medicaid, AMA tax, tax,
Rachael: all the beautiful hidden things. I like
Eric: that. I said I'm trying to distill and then I went on this.
Tiring it. He's not,
Rachael: not. So essentially while we're discussing how complicated, yes there are rules, the rules and things are, it is not to say that. That complication negates the value of, no,
Eric: it's fantastic. Ross accounts, you should certainly use them.
Rachael: Correct. It's just that in using them, you wanna be well educated and knowledgeable about the rules, so you're using them appropriately and to your best benefit.
And if it is something that you want to know more about, there are a host of professionals that are available that can help walk you through them. Yeah. There are
Eric: resources online.
Rachael: Correct. And um, you know, there are people who will approach us. Um, asking for help with like Roth conversions over a number of years.
Eric: Sure.
Rachael: Or identifying how much to contribute, um, or convert to their Roth just for this year, whatever the case might be. There are professionals who are available if it's too daunting. Yeah. But please don't. Avoid the Roth conversation. Yeah. 'cause it's overwhelming. Say I
Eric: just long-winded, we wanna say, yeah, Roths are great.
Use them. They're,
Rachael: um, okay. So we've had, we've talked about Roths many times over the existence of our podcast and because we've gotten so much interest in questions on this topic, this is why we're kind of doing the three episode. Um, miniseries, but, um, I pulled some questions from that We've gotten previously about Roth Basics for you to kind of distill those answers there.
Eric: Hopefully I can
Rachael: distill, hopefully
Eric: I can get it done.
Rachael: So there's three of them. Okay. The first one, can I contribute to both a Roth IRA and a Roth 401k in the same year?
Eric: Yes. And with the same funds.
Rachael: So that's pretty incredible. So when you say with the same funds, like, I know I can only contribute, like, let's say that I'm under 50.
Mm-hmm. I can only contribute 7,000, right? If I'm 50 or over, it's eight.
Eric: Correct.
Rachael: Okay. Um, so I have a set number I can contribute and it has to be with earned income. So let's say I, um, on, I worked part-time this year I made $7,000.
Eric: Okay. Um.
Rachael: I have some savings as well, so I could contribute $7,000 to my Roth IRA.
Eric: Yep.
Rachael: Okay. I could also contribute 7,000 to my Roth 401k.
Eric: Correct. Your line 11 on your tax return is what we're going with here. That's your A GI And you're actually gonna add back some of the deductions to determine what you can, what your taxable, I'm sorry, what your, um, modified adjusted gross income is for Roth contribution purposes.
Mm-hmm. So. If you're making a Roth 401k contribution, you're not actually reducing your a GI at all. You're not reducing, you could essentially, essentially double in. Yes, you could if you wanted to and you had the taxable, uh, savings touc funds to do so. Yeah.
Rachael: Perfect. Um, so yes, so you can contribute to both and, um, if you're eligible and have the means, you could.
Max them both out as well. Alright, second question. What happens if I contribute, and we touched on this actually earlier, what happens if I contribute to a Roth IRA, but then I discover that I'm over the income limit?
Eric: You can speak with your custodian and recategorize your contribution. Or withdraw your contribution before the tax filing deadline.
If you leave the money in there, I think it's a 6% excise tax that you'll have to pay.
Rachael: Mm-hmm.
And the same thing goes for if you were to contribute, but you were under the amount of earned income that year. Same thing. Um, okay. And then our last question that I pulled for this episode, um, are there minimum, are there required minimum distributions for Roth accounts?
No.
Eric: It used to be for Roth 4 0 1 Ks. They, um, they discontinued that with secure Act 2.0 I believe.
Rachael: Excellent. So an important distinction between the Roth and non Roth accounts.
Eric: Correct.
Rachael: Um, alright, so those are essentially the. Basics for the Roth that I had, that I wanted to talk about. Is there anything else that you wanted to talk about?
Eric: That's it.
Rachael: All right. So essentially, um, main takeaways, right, are that the Roth accounts offer the tax free growth, um, option should be taken advantage of in years where your, um. A taxable income or your bracket is lower than what is expected to be in the future. Um, the five year rules determine, um, when those earnings can be withdrawn, tax free, um, and the Roth accounts are incredibly beneficial, which we're gonna dive into more in next week and the week after.
Eric: All righty. Thanks guys.
Rachael: Till next time!
