Personal Finance

The biggest things you probably don't know about Roth IRAs

Key Points
  • Roth IRAs let you put away post-tax money toward your retirement.
  • Many investors don't know the ins-and-outs of these accounts, according to recent research.
  • Following the rules can help you maximize your tax-free income when you're no longer working.
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You may be overlooking one retirement investment choice.

That's the ability to put away post-tax money through a Roth individual retirement account.

Recent research from TD Ameritrade finds that many individuals are confused when it comes to Roth IRAs. And that means many people are leaving cash on the table when it comes to maximizing this savings strategy.

"Roth IRAs, Roth conversions, are sometimes seen as really benefiting just wealthy taxpayers," said Christine Russell, senior manager of retirement and annuities at TD Ameritrade. "In fact, the Roth has benefits for many different taxpayers and many different tax brackets."

Here are the biggest things that investors typically do not know about Roth IRAs.

Roth IRA and 401(k) contributions are not the same

Many 401(k) plans now offer savers the ability to contribute post-tax money. But these savings are separate, which means you can make Roth 401(k) contributions and save in a Roth IRA at the same time.

The accounts are also subject to different rules. Roth savings options in 401(k) plans are subject to maximum limits for those accounts. In 2020, that will be $19,500, or $26,000 for individuals age 50 and over.

Roth IRAs are subject to earnings limits. For many individuals, that is less than $124,000 in modified adjusted gross income, or $196,000 if you are married and filing jointly.

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A Roth IRA is OK before hitting 401(k) max

Many workers get their retirement savings education from their employer.

Often, those employer-provided plans are 401(k) plans. And you generally want to contribute enough to that account to get the employer match.

But what many investors — 6 in 10 — erroneously believe is that you can only contribute to a Roth once you hit your 401(k) maximum, according to TD Ameritrade's research.

"You can certainly be contributing to both a Roth IRA and a 401(k) at the same time," Russell said. "You don't have to reach that 401(k) maximum in order to contribute to a Roth IRA."

Contributions can be made after 70½

Just 22% of individuals surveyed by TD Ameritrade said they know it's still possible to contribute to a Roth IRA after they reach age 70½.

Russell attributes that misconception to the fact that traditional pretax IRAs have prohibited individuals from making contributions after that age.

But that changed this year. A new law, the Secure Act, will now let individuals put away retirement savings in all types of IRA accounts beyond age 70½, provided you have earned income.

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There are advantages to saving in a Roth IRA, however, that investors should know about.

With Roth IRAs, the money you contributed can be taken out tax-free, because the money you invested was post-tax in the first place.

When it comes to the earnings on the money you invested in a Roth IRA, there's a five-year rule before you can take that out penalty-free (as long as you're older than 59½).

The good news is that the five-year rule on earnings is dependent on when you first open the account, Russell said.

That's why it's a good idea to open a Roth IRA as soon as possible, even if it's just with a small amount of money, to get that five-year clock ticking, Russell said.

Roth IRA conversions can mitigate tax bills

Just the term "Roth IRA conversion" alone tends to confuse people, Russell said.

But the strategy can be very valuable in helping savers manage their taxable income in retirement.

A Roth IRA conversion is when you move money from a pretax traditional IRA to a post-tax Roth.

This technique enables the after-tax money to grow and eventually become tax-free so that account holders don't have to pay taxes on it later on, Russell said.

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You can do multiple Roth IRA conversions in one year. It's a good idea to keep in mind what tax bracket you were in last year so that you don't push yourself into a higher tax bracket with this transaction, Russell said.

It's also wise to break up your conversions into pieces. If you want to convert $20,000 this year, for example, you could do it in two days to try to sell on market lows.

You may also want to break your conversions up over a few tax years, Russell said.

One caveat: Since the Tax Cuts and Jobs Act was passed in 2017, you can no longer reverse those conversions.

"Being a little bit more strategic when doing your conversion is important, because you can't undo it," Russell said.

Roth IRAs can help control Medicare costs

Having more taxable income in retirement can get expensive, even if you're middle class, because what you pay for Medicare Part B is based on your taxable income in retirement.

Medicare Part B premiums are particularly tricky because even if you earn just one more dollar, you could have to pay hundreds of dollars more for your premiums as a result.

To help guard against that, you may want to use Roth IRAs to provide tax-free income in retirement.

"The benefit is that it's not going to increase your Medicare Part B premium," Russell said.

TD Ameritrade's survey of 1,015 adults ages 23 and up with at least $10,000 in investible assets was conducted in August.

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