understanding gift tax

Roth IRA – The Ultimate Guide

The Roth IRA seems like a simple retirement account at first glance.

But there are some intricacies to the Roth IRA that can leave even the best minds confused. To start with, the Roth IRA has several 5-year rules that occur at different times and under different circumstances. The Roth IRA is not an easy account to contribute to but there are workarounds for that.

The Roth IRA can be a great retirement vehicle even though it can be confusing at times. Understanding when to contribute, when to withdraw, and all the rules involved can save you both headaches and money in retirement.

What is a Roth IRA

A Roth IRA is an individual retirement account, much like a Traditional IRA account. The money that is contributed to a Roth IRA is done with after-tax money. A Traditional IRA lets you deduct the money you contribute on your taxes, a Roth IRA does not. The payoff here is that the money that comes out of a Roth IRA is tax-free, while a Traditional IRA is not. We classify a Roth IRA as a never taxable account. That means that the money coming out will never be taxed. A Traditional IRA is an always taxable account.

The process of opening a Roth IRA account is simple. You can go to your favorite online discount brokerage, TD Ameritrade, E-Trade, etc. and open a Roth IRA account. The contribution deadline is the tax filing deadline without extensions. This deadline is typically around April 15th but can change slightly depending on how the day falls. If you contribute before this date, you can count the contribution towards the prior year. For example, a 2018 contribution must happen before April 15, 2019. This helps if you forget to contribute in the prior year and still want to contribute for the current year.

To contribute to a Roth IRA, you need to start with earned income. If you or your spouse has earned income in the form of wages, salaries, tips, bonuses, commissions, or self-employment income, you can contribute up to that amount. This does rule out a lot of younger people who are not yet working from starting their Roth IRA account.

You do not have to contribute your earned income, though. If a young person has a first job and is making a little money, the parents can contribute to the kid’s Roth IRA. If the kid is not working, and does not have earned income, the parents cannot contribute.

The maximum you can contribute is the lesser of your earned income or $6,000. If you are over the age of 50, you are given an additional $1,000 catch up contribution. For example, if you only earned $4,000 in income this year, the max you can contribute to a Roth IRA is $4,000.

A Roth IRA and a Traditional IRA use the same pool of money. You cannot contribute $6,000 to one account and then contribute $6,000 to the other. The total contributions for the two IRA accounts must not be greater than the lesser of earned income or $6,000. You can contribute $3,000 to your Roth IRA and $3,000 to your Traditional IRA.

There are also limits on the amount of earned income you can earn before you no longer can contribute to a Roth IRA. If you are single, and your income is below $122,000, you can contribute the full amount to a Roth IRA. Once your income is above $137,000, you can no longer contribute to a Roth IRA. If you are married filing jointly, you can have income up to $193,000. Once your combined income is above $203,000, you can no longer contribute to a Roth IRA.

There are no age limits on Roth IRA contributions. There is not a minimum age requirement nor is there a maximum age limit. A Traditional IRA stops you from contributing once you reach age 70 ½ but that restriction is not there for a Roth IRA. You can contribute to a Roth IRA well into your 70’s or 80’s.

Withdrawing Money from a Roth IRA

A Roth IRA has a lot of perks when it comes to taking money out. A Traditional IRA wants you to keep money in the account until the age of 59 ½ but a Roth is more lenient.

First, direct contributions to a Roth IRA can be taken out at anytime without penalty or tax. The IRS has decided that you have already paid taxes on your Roth IRA contribution, so they don’t have to worry if you take that money back out. That means, you can contribute this year and next year remove that money back out. This gives you a lot of flexibility especially if you don’t know what is ahead for you financially.

The earnings on the money you have contributed cannot be taken out early without tax and penalty. This is money you have not paid tax on, so the IRS wants you to keep it in the account until age 59 ½. If you remove this money early you will have to pay a 10% penalty on the amount you remove. This money will also count as ordinary income and you will have to pay income taxes on it.

After the age of 59 ½ you can remove all the money tax and penalty free. The whole point of the Roth IRA is to let your money grow tax-free, so you want to keep the earnings in the account until you reach the right age.

With any good rule there comes exceptions, and the Roth IRA withdrawal is no different.

When you are under the age of 59 ½ and need to remove earnings from the account there are a few exceptions that will allow you to get the money out either penalty free or tax and penalty free. Again, contributions to the account can always be removed tax and penalty free.

If the account is less than 5 years old, there are certain exceptions for distributions from your earnings where you only pay tax, no penalties. It is ideal that you start a Roth IRA early in life to knock this 5-year rule out. We will discuss this 5-year rule and the other 5-year rule below.

The following exceptions are considered taxable but no 10% penalty:

  • Qualified education expenses: The IRS defines qualified education expenses as expenses for tuition, fees and other related expenses such as books and materials. Room and board or transportation to and from school do not count as qualified education expenses.
  • Unreimbursed medical expenses: If you’ve incurred medical expenses that are not being reimbursed and are above 10% of your AGI, you can access your Roth IRA to help cover the costs. It is best to leave this exception alone unless you absolutely need the amount to cover your medical bills. The IRS will look very closely at the expenses you are trying to cover.
  • Health insurance premiums while you are unemployed: Again, the IRS will let you cover some medical costs with your Roth IRA. In dire situations will we recommend pulling money from retirement accounts to pay for these expenses.
  • Series of substantially equal periodic payments: This exception is also known as a SEPP. You must remove the money in equal distributions for the greater of you reaching the age of 59 ½ or for a minimum of 5 years. If you start this at age 50, you will have to keep this payment plan going for 9 ½ years. If you start this payment plan when you are age 59, you will have to turn 64 before it is over. This is a tricky method and one mistake will cost you a lot of money in penalty and taxes.
  • First-time home purchase: You can use $10,000 of your Roth IRA for a first-time home purchase. The IRS has a very loose definition of “first-time”. You can have multiple “first-time” home purchases throughout your life. If you haven’t owned a home in the last two years, you qualify as a first-time home purchase.

Those are your exceptions for your distributions if your account was opened less than 5 years ago. You will be forced to pay taxes on the amount of earnings withdrawn but not the 10% penalty. For example, you have a Roth IRA account with $50,000 in contributions and $50,000 in earnings. It hasn’t been open 5 years and you want to remove $60,000 for a first-time home purchase. The first $50,000 would come from your contributions which would be tax and penalty free. The next $10,000 would come from your earnings which you would owe taxes on but no penalties.

Once you’ve held a Roth IRA account for 5 years, you can withdraw money as qualified distributions. A qualified distribution is not subject to taxes or a 10% penalty. The following are qualified distributions:

  • You are age 59 ½: At this point you can start withdrawing some or all your money out of your retirement account.
  • You are permanently and totally disabled: Once you become disabled the IRS allows you to access your money, so you can replace your income and take care of yourself.
  • First-time home purchase: Just like taking out money for a first-time home purchase as an exception, this time you won’t have to pay tax or penalty on the money.

When removing money from a Roth IRA, the order is always contributions first, conversions second, and earnings third. You know the limits to contributions and earnings are self-explanatory, but there is a third way to fund your account: conversions. That is when you convert money from a Traditional IRA to a Roth IRA and it comes with its own set of rules.

5-Year Rule: Holding an Account for 5 Years

As you can see it is much better to make qualified distributions versus exceptions from a Roth IRA. You can avoid the penalty on both but with a qualified distribution, you will avoid the tax too. This is extremely important if you are nearing the age of 59 ½ and expect to start taking money out. Just because you’ve reached the retirement age doesn’t mean you can pull money out tax free if the Roth IRA hasn’t been opened for at least 5 years.

The IRS sees all your Traditional IRA accounts as one big Traditional IRA account. Similarly, they see all your Roth IRA accounts as one big Roth IRA account. If, for some reason, you have 5 different Roth IRA accounts, the IRS will see it as one big balance.

The IRS wants you to have a Roth IRA account open for at least 5 years. It doesn’t matter which Roth IRA you are contributing or withdrawing from, if at least one has been open for 5 years. You open a Roth IRA account at the age of 10 with $100, and never put money in that account again. Later in life you open another Roth IRA account and contribute to that. Next year you decide to withdraw $10,000 of contributions and earnings for a first-time home purchase. That money would be a qualified distribution and come out penalty and tax-free. It does not matter that you did not pull money from your oldest account, it only matters that you have that account.

Therefore, it is ideal to open a Roth IRA early in life, at least with a small contribution. If you go through life without opening a Roth IRA, it will make it difficult to tax plan in the future. There are a lot of ways to move money between accounts and lower your tax bill, but you need to start the 5-year rule to make that happen.

This rule only happens once in your life. It does not restart every time you open a new Roth IRA account. The date that is considered the start date is January 1 of the contribution year. If you open a Roth IRA and contribute to the account on April 13, 2019, the 5-year rule will start on January 1, 2018. You are being gifted 13 months.

5-Year Rule: Converting Money into a Roth IRA

When you convert money into a Roth IRA from a Traditional IRA or other retirement vehicle, you will start a new and different 5-year rule. This 5-year rule stats that any conversions you make, need to be left in the account for at least 5-years. If you removed the converted money before the 5-year rule is up, you will face a 10% penalty on the money withdrawn. You will not pay any tax on the money because you did that when you converted it over.

Each conversion you make will have its own 5-year rule. You cannot make one and be done for the rest of your life. The IRS does not want you to be able to convert money from a Traditional IRA, so you can take the money out today. If that were the case, the IRS would never get its 10% penalty if you withdrew money from an IRA account early.

When you start withdrawing converted money, the IRS will take the oldest converted money first. If that money has already reached its 5-years, you won’t have to worry about it. After that converted money is expended, the IRS will move onto the next batch of converted money until the distribution has been met.

Understanding Backdoor Roth Contributions

Due to the tax implications of a Roth IRA, it is naturally for people to want to move some money into these accounts. The contributions will grow tax-free which is a huge advantage of a Roth IRA. Along with tax-free earnings, the Roth IRA will not have required minimum distributions. This tax diversity and lack of required distributions will be a great advantage to you when approaching retirement.

Unfortunately, the government has stepped in a limited the ability to open and fund a Roth IRA. It has set income thresholds that if met, mean you no longer can place money into your Roth. It is unknown why the government decided to implement this rule, but there are workarounds.  

While there are rules on the Roth IRA, there are no such rules on a Traditional IRA. There are no income limits for Traditional IRA contributions, there are only income limits for making a deductible contribution.

There are also no rules for converting Traditional IRA money into a Roth IRA. The strategy from moving money from a Traditional IRA to fund a Roth IRA is known as a backdoor Roth contribution.

The easiest way to perform this strategy is to contribute into your Traditional IRA, and the next day tell your custodian to convert that money to your Roth IRA. You can make multiple conversions a year, for any amount.

When you make the conversion, you will have to pay tax on that money. This should be expected since funding a Roth IRA is done with after-tax money. For example, you make a $6,000 contribution to your Traditional IRA, you deduct that $6,000 from your taxes, you convert that money over to a Roth IRA, you add that $6,000 back into your ordinary income.

It doesn’t have to be just the money you contributed today that you move into your Roth IRA. You could move your entire Traditional IRA into a Roth IRA. Remember, you will have to pay taxes on that money this year, so moving it all over might not be the best idea.

Where this strategy becomes complicated is when you have nondeductible contributions in your Traditional IRA. If you make a nondeductible contribution into your Traditional IRA, you can convert that money to a Roth IRA and not owe any taxes. A nondeductible contribution is done with after-tax money so there is no future tax bill.

However, the IRS will always view your Traditional IRA accounts as one big bucket of money. It doesn’t matter if you have multiple Traditional IRA accounts, to them it is one big account. If you have before tax money (contributions you deducted) in a Traditional IRA and you add nondeductible contributions, you cannot get that money out separately. To the IRS it becomes one big pot of money and when you convert money to the Roth IRA, some of it will be after-tax money and some of it will be pre-tax money.

Here is an example. You have an IRA with $200,000 in pre-tax money. You are now above the income threshold to contribute to a Roth IRA and above the limit to make a deductible contribution. You contribute another $6,000 to your Traditional IRA and convert that money into a Roth IRA. The IRS will see that you converted 3% of your nondeductible contribution and 97% pretax money. You will owe taxes on $5,820 of the conversion. Only $180 of that money will be from your nondeductible contribution. You will also have to keep track of this amount going forward for the IRS.

Not only does this become complicated to track, but if you are not allowed to make a deductible contribution or fund a Roth IRA, you are probably in a higher tax bracket and want to avoid converting pretax money over.

The only way to overcome this obstacle is to take all your pretax contributions, in our example the $200,000, and roll that money into your employer retirement plan, if they allow it. Once there is no more pretax money in your Traditional IRA, you can contribute after-tax money, and convert it over to a Roth IRA with no issues.

There used to be issues between the IRS and congress on if a backdoor Roth contribution was allowed. The IRS has a rule called the step-doctrine. This rule states that if a series of transactions designed and executed as part of a unitary plan to achieve an intended result, will be viewed as a whole. Basically, that means if the result is against the rules, it doesn’t matter to the IRS how you got there, legally or not. If they didn’t want you to fund a Roth IRA, doing so through a backdoor Roth contribution is also not allowed. While this has been debated back and forth for many years, the IRS came out at the end of 2018 and blessed the backdoor Roth contribution and said it is allowed.

Using Roth Conversions to Lower Future Taxes

Reducing taxes in retirement takes planning ahead of time. Once you are already past the age of 70, the ability to reduce taxes greatly diminishes. It is at that age that you are forced to take all this money out of your retirement accounts plus social security so the opportunity to plan is gone.

Most people do not wait until they are 70 years old to retire, even though that is when you start collecting the most benefits. A lot of people will begin to retire in their 60s which is great for advanced tax planning.

Once you retire, your yearly income drops significantly and that puts you in a lower tax bracket. Think of a chart of your tax brackets throughout your life. At the beginning of your career you have very little income, so you are in a much lower tax bracket. As your career progresses your income begins to rise and so does your tax bracket. In your 40s and 50s, you are beginning to really excel in your career and bring in a large income. This is when your tax bracket is the highest. It may start at 10% in the beginning and slowly rise to 32% throughout your life. At this level, you do not want to do a lot of retirement tax planning because you are paying the most tax in your life. Once you retire, your income drops, and you may fall back into the 12% bracket. Now, you have all these assets and you are in a lower bracket, this is the tax planning window you want to take advantage of. Once you hit 70, you are forced to take your retirement money and your tax bracket could rise again.

First, you can begin to convert money from an always taxable account to a never taxable account. This will allow you to pay tax now, while you are in a lower tax bracket. This will also reduce your future required minimum distributions because they will not be required in your never taxable accounts. You must make the conversion before December 31st of the current year.

Converting money from one type of account to the next has become a lot harder with the new tax laws in place. The idea is that you want to fill up your tax bracket and stop before it pushes you into a higher tax bracket. Before, if you made a mistake you could simply hit the undo button and fix everything. There is no more undo button, so you must do a bit more planning to make this work. Remember, when you take money out of your taxable accounts, it counts as income. If you take too much out it will push you into a higher tax bracket, and that is not what we want to do.

It is usually easy to predict most of your income, but there is a bit that becomes unpredictable. The salary is usually set in stone but could vary depending on hourly work, contract work, or commissions. You will also have to know if you are going to get any year-end bonuses, income from partnerships, or distributions. If you have a brokerage account, you will need to consider your trades or year-end distributions from mutual funds.

Knowing all this information with any certainty before December 31st is almost impossible. But there is a work around to buy you some extra time to make Roth conversions.

Before we begin, there is a bit of caution that is needed here. You should only attempt to do this with a professional. Forgetting, making a mistake, or improper timing can cause you to realize a lot of income and get hit with a huge tax bill.

Let’s proceed.

Before December 31st, you want to make an indirect rollover with your Traditional IRA. This will be an indirect rollover, so the custodian will send you the money. In a direct rollover, the custodian sends the money to the other custodian, and this is not what we want. In an indirect rollover, you have 60-days to move the money to the new account. If you start this process by December 15th, you have until February 15th to finish the transaction. During this time, you will receive a lot more definitive information about your income sources and how much you need to convert into a Roth IRA.

Once you know how much you need to convert, send a check to your Roth IRA account for that amount. Take the rest of the money that you didn’t convert and put it back into your Traditional IRA account. If you take longer than 60-days to complete this process, you’ve just created a distribution and will be hit with tax and penalties.

If you want to buy yourself another week, have your custodian send you a check versus an electronic deposit into your account. The IRS does not start the 60-day clock until you have touched the check. They’ve had problems with people being in prison or on vacation and not being able to access the money to complete the rollover. Don’t try to push it longer than a week or you will have to show proof of why you couldn’t touch the check.

Because this is now a rollover and no longer a conversion, you can only complete one a year. If you plan to do this every year, you need to do it one day later than last year. If you started the process on December 15th, 2018, you cannot start the next one until December 16th, 2019. This is the start of the process date, not when you touched the check or received the money.

The Mega Backdoor Roth

The mega backdoor Roth is a backdoor Roth contribution on steroids. The mega backdoor Roth allows you to contribute large sums into your Roth IRA at once. Instead of requiring a Traditional IRA account, this method requires a 401K account that allows after-tax contributions. That is not, a Roth-401k account. A Roth 401k does not work in this situation even though that money could be considered pretax. Most 401k contributions are going to be pre-tax contributions. They come out before you receive your paycheck and before you’ve had the chance to pay tax on the amounts. Some 401k accounts allow you to elect a non-Roth after-tax employee contribution.

The money elected to be contributed to the non-Roth after-tax portion does not count towards the $19,000 401k employee limit. If you’ve determined that your employer does allow non-Roth after-tax contributions to their 401k account, you also need to determine if you employer allows in-service withdrawals in their 401k plan. If they do not allow these withdrawals, you will have to wait until you separate from service before using the mega backdoor Roth.

How does this process work?

First, you can contribute up to the maximum allowed in a 401k plan. In 2019, that means you can contribute up to $19,000 a year. Your employer can contribute another $37,000 a year for a maximum contribution up to $56,000. Most employers are not going to contribute that much into your 401k, especially if you are only putting in $19,000. If you are putting in $19,000 in, your employer is putting another $10,000 in, you are still left with $27,000 capacity to completely max out your 401k. Unfortunately, you have already hit your limit and can no longer contribute anymore pre-tax money. This is where the non-Roth after-tax money would come into play. A Roth 401k would be maxed too, it shares the same limit as a standard 401k. You can contribute up to $27,000, in this example, in non-Roth after-tax money. This would completely max out your 401k. You would have $19,000 in pre-tax contributions, $10,000 in employer contributions, and $27,000 in non-Roth after-tax contributions for a total of $56,000.

Once you have that money in place, this system works just like a regular backdoor Roth. You simply convert the non-Roth after-tax money to a Roth IRA. If there are no gains on that money, the money will move over without any tax liability or penalty.

If your employer doesn’t allow in-service withdrawals, so you cannot move the money over when you want, you will have to wait until you separate from service before moving the money to a Roth IRA. The bad part about waiting is that you will now have earnings building up in that account, which you will be taxed on when you move the money.


The Roth IRA is a great retirement vehicle. It allows you to pay tax now on your contribution, so you can remove the entire sum in retirement, tax-free. This is one of the few accounts that we deem as never taxable and will add tax diversity into your retirement plan.

You want to open a Roth IRA account early in life. First, you need to get that firsts 5-year rule behind you. Second, Roth IRA’s are typically the best retirement account to invest into while your earnings are still low. You want to pay the tax while you are in a lower tax bracket to get the full advantage of contributing to this IRA account.

Unfortunately, the government has done their best to restrict who can invest in a Roth IRA account, but there are workarounds. You can do backdoor Roth contributions from your Traditional IRA account to get money in there. You can also do a mega backdoor Roth contribution from your 401k account that can get a lot of money in there quickly.

When doing these backdoor Roth contributions, make sure you are aware of the tax consequences before proceeding. Understanding the types of retirement accounts, you have open can affect how a conversion is taxed. You can also convert too much and push yourself into a higher tax bracket. There used to be an undo button but that has been removed.

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