Chapter 3 — Roth IRAs

The Roth IRA, created by the Taxpayer Relief Act of 1997 and named for Senator William Roth, differs fundamentally from traditional IRAs. No contribution to a Roth IRA is ever tax-deductible — contributions are always made with after-tax dollars. The earnings grow tax-deferred, and with few restrictions, all distributions from the account are completely tax-free.

In a traditional IRA, tax benefits occur when deductible contributions are made and as earnings compound tax-deferred — the tax liability is deferred until withdrawal. In a Roth IRA, the tax benefits occur as the account grows and when funds are withdrawn. This delayed nature of the tax advantage is why Roth IRAs are called “backloaded” IRAs.

Unlike traditional IRAs, Roth IRAs impose no required minimum distributions during the owner’s lifetime, and contributions may be made at any age as long as the owner has earned income and income remains below the applicable threshold.

Any person with earned income may open and contribute to a Roth IRA — there is no age restriction. The same annual contribution limits apply as for traditional IRAs, and the limit applies to the combined total of all IRA contributions for the year (traditional + Roth).

Unlike traditional IRAs, high-income earners are prohibited from contributing to a Roth IRA. The contribution limit phases out over the following 2026 MAGI ranges:

Within the phase-out range, a partial contribution is permitted. Above the upper limit, no Roth IRA contribution is allowed. Individuals who cannot contribute to a Roth IRA due to income may contribute to a traditional IRA instead, though the deductibility of those contributions will depend on their active participant status and income.

To be treated as a Roth IRA, the account must be designated as a Roth IRA when established. Roth IRA funds must be held in a separate account from traditional IRA funds — unlike traditional IRAs which can hold both deductible and nondeductible contributions in a single account, Roth contributions cannot be commingled with traditional IRA balances.

Excess Roth IRA contributions — whether due to exceeding the dollar limit or the income limit — are subject to the same 6% annual excise tax as excess contributions to traditional IRAs. The excess (plus earnings) should be withdrawn by April 15 of the following year to avoid the penalty. Alternatively, excess contributions may be corrected by underfunding future years.

The key advantage of a Roth IRA is that qualified distributions are completely tax-free. To be a qualified (tax-free) distribution, two conditions must both be met:

The distribution must occur at least five tax years after the first Roth IRA contribution was made. The five-year period begins on January 1 of the tax year for which the first Roth IRA contribution was made — not the calendar date the contribution was actually deposited. Because contributions may be made up to April 15 of the following year and designated for the prior tax year, the holding period may effectively be less than five full calendar years.

In addition to the five-year rule, the distribution must be made:

• on or after the owner reaches age 59½,
• to a beneficiary upon the owner’s death,
• due to the owner’s disability, or
• for qualified first-time homebuyer expenses (lifetime limit of $10,000).

If both the five-year rule and one of the four qualifying events are satisfied, the distribution is qualified and entirely tax-free — including all accumulated earnings.

If a distribution does not satisfy both the five-year rule and a qualifying event, it is a non-qualified distribution. Non-qualified distributions are taxed under a FIFO (first-in, first-out) ordering rule — contributions are always deemed to be distributed first, then earnings.

Because Roth IRA contributions were made with after-tax dollars, the return of contributions is always tax-free, regardless of when distributed. Only when total distributions exceed total contributions does the taxable earnings portion begin to be distributed.

Non-qualified distributions from Roth IRAs and nondeductible traditional IRAs are treated differently, even though both are funded with after-tax contributions:

• Roth IRA: FIFO — contributions come out first (tax-free), then earnings (taxable). A partial withdrawal is entirely tax-free until all contributions are recovered.
• Nondeductible traditional IRA: Pro-rata rule — each withdrawal is partly tax-free (in proportion to basis) and partly taxable (earnings). A partial withdrawal always includes a taxable portion.

This distinction matters significantly when considering a partial early withdrawal — the Roth IRA’s FIFO treatment is generally more favorable.

While the earnings portion of a non-qualified Roth IRA distribution may be taxable, the contributions themselves are never subject to the 10% premature withdrawal penalty — because they are always returned tax-free first under the FIFO rule. This makes a Roth IRA significantly more accessible than a traditional IRA for younger individuals who may need to access funds in an emergency.

One of the most significant advantages of a Roth IRA over a traditional IRA is the complete absence of required minimum distributions (RMDs) during the owner’s lifetime. Traditional IRA owners must begin taking RMDs at age 73 (age 75 for those born after 1959). Roth IRA owners face no such requirement — funds may remain in the account indefinitely and continue growing tax-free.

This feature makes Roth IRAs particularly powerful for:

• individuals who do not need to draw on retirement savings and wish to pass assets to beneficiaries with maximum tax-free growth,
• individuals who want to avoid the income-increasing effect of RMDs (which can push Social Security benefits into taxable territory or trigger Medicare premium surcharges), and
• estate planning purposes — a Roth IRA passed to a non-spouse beneficiary continues to grow tax-free during the beneficiary’s 10-year distribution period.

Roth IRA owners may also continue making contributions at any age as long as they have earned income below the applicable phase-out threshold.

Distributions from one Roth IRA may be rolled over tax-free to another Roth IRA, following the standard IRA rollover rules: redeposit within 60 days and no more than one rollover per year. Direct trustee-to-trustee transfers between Roth IRAs may occur without limit.

Assets held in a traditional IRA may be moved into a Roth IRA through a conversion. There are no income limits for Roth IRA conversions (the $100,000 AGI limit was eliminated in 2010). Key rules:

• The taxpayer must pay ordinary income tax on the converted amount in the year of conversion — as if the amount had been distributed from the traditional IRA. The 10% premature distribution penalty does not apply to conversions.
• Married individuals filing separately may convert (this was restricted prior to 2010).
• A new five-year holding period begins with the tax year of the conversion for that converted amount (for penalty purposes on early withdrawals of the converted principal).
• Conversions may be made by notifying the IRA trustee directly, or via trustee-to-trustee transfer. The “once per year” rollover rule does not apply to traditional-to-Roth conversions.
• If only part of a traditional IRA is converted, the converted Roth amount must be held in a separate Roth IRA account.

The decision to convert is complex and highly individual. Converting triggers an immediate tax liability in the year of conversion. Other factors to consider:

• Will the higher income in the conversion year push the taxpayer into a higher bracket?
• Will higher AGI cause Social Security benefits to become taxable, or trigger Medicare premium surcharges (IRMAA)?
• Will higher income reduce eligibility for other deductions, credits, or financial aid?
• How many years does the taxpayer have for the tax-free earnings to outweigh the upfront tax cost?

Generally, conversion makes the most sense when the taxpayer expects to be in a higher tax bracket in retirement than at the time of conversion, has many years for the account to grow, and can pay the conversion tax from non-IRA funds.