For most of us, retirement is a time to travel and do the things we did not have time to do while working. But that means having the money in your retirement portfolio to do them and making that money last for the rest of your life. Roth IRAs are an essential component of a balanced retirement investment portfolio.
Conventional investing wisdom holds that you should preferentially invest in Roth IRAs when you are young and have a lower taxable income and then preferentially invest in tax-deferred investments (such as a 401k or traditional IRA) when you are older and have a higher taxable income. The premise behind this is that you pay income tax on the money in a Roth IRA when you contribute the money during your working years and pay income tax on tax-deferred investments when you take the money out during your retirement years. Because most people have their lowest taxable income in their early working career years, a higher taxable income in their retirement years, and the highest taxable income during their later working career years, this strategy results in paying the lowest amount in taxes over one’s lifetime.
But should you contribute to a Roth IRA after you retire? The answer is… it depends.
First, you have to have an income
In order to contribute directly to an IRA, you have to have earned income, either as a salaried employee or from contract work. With the former, your income is reported on a W-2 form and with the latter, your income is reported on a 1099 form. If your taxable income is low enough, you can contribute directly to a Roth IRA; otherwise, you can only contribute by doing a “backdoor Roth IRA” by first contributing to a traditional IRA and then promptly converting that money into a Roth IRA. The income limits are complicated so you should review the 2024 IRS rules to see how your specific situation affects your ability to contribute. But as an example, for a single person who does not have access to an employer-sponsored retirement plan, the income limit for direct contribution to a Roth IRA is $146,000 and for a married couple filing jointly, the income limit is $230,000. Many Americans over age 65 are no longer working full-time for an employer but instead are working part-time as contract workers and are thus not eligible for an employer-sponsored retirement plan.
If all of your income comes from a pension, 401(k), 403(b), 457, Social Security, and/or traditional IRA, then you cannot directly contribute to a Roth IRA – you must have annual income that you have earned during that year. Furthermore, you cannot contribute more than you actually earned. The IRA contribution limits in 2024 are $7,000 if you are younger than 50-years-old and $8,000 if you are over age 50. If you do not have any earned income, then you cannot contribute directly to a Roth IRA or do a backdoor Roth contribution. However, anyone can do a Roth conversion, regardless of whether or not they have any earned income.
If you have money in a tax-deferred retirement account (traditional IRA, SEP IRA, 401k, 403b, or 457), you can convert some or all of that money into a Roth IRA. The catch is that the amount that you convert adds to your taxable income for the year of the conversion. As a result, the more you convert, the higher your taxable income will be and consequently the higher your marginal income tax rate will be.
There are two ways of doing Roth conversions: a direct rollover and an indirect rollover. In a direct rollover, the administrator of your tax-deferred retirement account delivers the converted amount directly to the financial institution holding your Roth IRA and you never touch the money. Direct rollovers are simple and low-risk. In an indirect rollover, you withdraw funds from your tax-deferred retirement account and put those funds into your checking/savings account and then you transfer that money into your Roth IRA yourself. Indirect rollovers have a minor element of risk – you only have 60 days from the time you receive the distribution from your tax-deferred account to the time you deposit it into your Roth IRA. After 60-days, you are no longer permitted to put that money into your Roth IRA.
Before doing a Roth IRA conversion, it is essential that you have an idea of when you will need to eventually withdraw the money from your Roth IRA because conversions are subject to the IRS 5-year rules.
The 5-year rules
The IRS looks at each Roth IRA as having three components: contributions, earnings, and conversions. Contributions are the dollar amount that you put into the Roth IRA each year that you do a direct contribution. Earnings are the dollar amount that the initial direct contributions grew by before you withdraw them from the Roth IRA. Conversions are the dollar amount that you either did with a backdoor Roth, a direct rollover, or an indirect rollover. Each of these components have different rules regarding when you can withdraw them from a Roth IRA. These 5-year rules can impact whether or not it makes sense for you to contribute to a Roth IRA after age 65.
- Contributions. These can be withdrawn anytime from your Roth IRA without penalty.
- Earnings. These can only be withdrawn after (1) you turn 59 1/2-years old and (2) at least 5-years have elapsed since your very first contribution to the Roth IRA. Early withdrawal results in significant penalties.
- Conversions. These can only be withdrawn after (1) you turn 59 1/2- years old and (2) at least 5-years have elapsed since the amount withdrawn was converted. Each conversion has its own 5-year requirement so, for example, you can take the amount of your 2023 conversion out in 2028 but you cannot take the amount of your 2024 conversion out until 2029.
There are also separate rules regarding the timing of withdrawals from inherited Roth IRAs. The rules are complex but in general, if you inherit a Roth IRA from someone other than your spouse, you are required to withdraw all of the money from that Roth IRA within 10 years of the inheritance if you are listed as a designated beneficiary on the Roth IRA. If you are not listed as beneficiary and instead just inherit it through a will, then you only have 5 years after the date of inheritance to withdraw all of the funds.
So, I’m older than 65, should I put money in a Roth IRA?
The decision of whether or not to contribute to a Roth IRA or do a Roth conversion requires some strategic planning. Here are some situations where it can be advisable or not advisable to put money into a Roth when you are over age 65-year-old.
People who should put money in a Roth IRA:
- You anticipate that your taxable income is going to go up in the future. In your first year or two of retirement, you may be living off of your cash or your regular (non-retirement) investments. You probably will not yet be taking Social Security. If this is the case, then you are only paying taxes on your investments’ interest, dividends, and capital gains resulting in your taxable income being fairly low. This is a good time to either contribute to a Roth IRA (if you have some earned income from part-time work) or do a Roth conversion because you will have a lower marginal income tax rate (i.e., you will be in a lower income tax bracket) than you will be in the future.
- You anticipate that tax rates are going to go up in the future. We are living in an era of historically low income tax rates that went into effect in 2017. However, these tax rates automatically expire at the end of 2025. Unless congress passes new tax laws to extend these cuts, everyone’s income tax rates are going to go up in 2026. If tax rates do go up, then 2024 and 2025 will be good years to put money into your Roth IRA. This is especially true for Roth IRA conversions – you will pay less in taxes to take out money from your 401k or traditional IRA now to convert into a Roth IRA than you will to take that same amount of money out of your 401k or traditional IRA to spend starting in 2026. We may have a more clear picture about future tax rates after the 2024 elections.
- Your investments have recently lost value. The goal of investing is to buy when it is low and sell when it is high. When you do a Roth conversion, then you are essentially buying shares of that Roth investment. The value of stocks and bonds goes up and goes down. If you convert a traditional IRA or 401k when it has recently lost a lot of value, then you will pay less in taxes on that conversion than you will when the value of that traditional IRA or 401k eventually goes up. In the summer of 2022, the stock market tanked and lost 27% of its value – that was a great time to do a Roth conversion. Since 2022, the stock market has regained that 27% and you will incur a lot more in taxes to convert any given percentage of your traditional IRA or 401k today than you would have in September 2022. If the stock market continues to go up in the next few years, then 2024 could still be a good year to do a Roth IRA conversion but no one has a investment crystal ball to predict the future.
- You anticipate RMD pain. When you turn 73, you are required to take a certain percentage out of your tax-deferred retirement accounts such as your traditional IRA, SEP IRA, 401(k), 403(b), and 457. These are called required minimal distributions (RMDs) and they add to your annual taxable income. If you have a lot of money in these accounts, then starting at age 73, your annual taxable income could go up significantly. As your taxable income goes up, so does your marginal income tax rate, meaning that you will pay exponentially more in taxes. You can lower the amount of the RMDs by doing Roth IRA conversions before age 73 to reduce the overall value of your tax-deferred investment accounts. Your RMD is based on your life expectancy – as an example, the RMD on a $1,000,000 tax-deferred account for someone turning 73 this year is about $40,000 per year. Unlike tax-deferred retirement accounts, Roth IRAs are not subject to RMDs.
- You want to maximize your estate for your heirs. If you do not anticipate needing to use the money in your Roth IRA for yourself during your lifetime then you may be able to allow the value of that Roth IRA to increase undiminished by required minimum distributions, thus leaving more for your heirs to inherit.
People who should not put money in a Roth IRA:
There are certain situations when you want to avoid doing Roth IRA conversions in retirement. Here are some considerations
- If it makes your Medicare premiums go up. For the vast majority of Americans, Medicare Part A is free. But we all have to pay monthly premiums for Medicare Part B and the amount of those premiums is based on your income. Medicare Part D premiums vary by the specific Part D plan level you choose but regardless of the level, the amount of the premium also increases based on income. When you do a Roth conversion, your taxable income that year goes up by the amount of the conversion and this could push you into a higher Medicare Part B and Part D premium bracket. The tax advantages of a Roth IRA conversion can be wiped out by the increase in your Medicare premiums. For example, if your taxable income is $249,999 and you do an $8,000 Roth IRA conversion, you will pay a total of $3,090 in Medicare Parts B & D premiums. But if you do an $8,002 Roth IRA conversion (just $2 more), then your Medicare premiums will go up by $1,503 to $4,593.
- If it moves you into a higher capital gains tax bracket. Regular income tax is a marginal tax rate system meaning that your tax rate increases incrementally for every additional dollar of taxable income. Short-term capital gains occur when you hold an investment for < 12 months and are taxed at your regular marginal income tax rate. Long-term capital gains occur when you hold an investment for > 12 months before you sell it. The long-term capital gains tax is not based on your regular marginal income tax rate but is instead based on your capital gains tax bracket. The capital gains tax rate is not a marginal tax, thus if your income pushes you into a higher marginal tax bracket, you will pay that higher tax rate on all of your capital gains. If you have a lot of capital gains, either because you were selling and buying investments over the course of the year or because you were taking money out of non-tax-deferred investments, then a Roth IRA conversion could push you into a higher capital gains tax bracket and those higher capital gains taxes could erase any tax advantages of the Roth IRA conversion. Here are the 2024 capital gains brackets:
- After age 73, things change. Once your tax-deferred retirement accounts become subject to required minimum distributions at age 73, you cannot use those RMD amounts to do a Roth IRA conversion. If you are working after age 73, you can still contribute earned income into a Roth IRA. You can also so a Roth IRA conversion on any money you take out of your tax-deferred retirement accounts over and above your RMD for that particular year. But for many people over age 73, doing a Roth IRA conversion on top of RMDs can push them into a higher marginal tax rate that erases any tax advantages of the Roth IRA conversion.
- You plan to give a large amount to charity. Once you turn 70 1/2, you can donate up to $105,000 directly from your tax-deferred accounts to charity via a qualified charitable distribution without having to pay income tax on the amount of those donations. And as a bonus, if you are over age 73, the amount of those donations count toward your RMDs! In this situation, Roth IRA conversions when you are younger can be counterproductive to your future tax-minimization strategy of charitable giving after age 73.
Diversify, diversify, diversify!
One of the most important reasons to have a Roth IRA (or Roth 401k or Roth 403b) is to have a diversified retirement portfolio. Ideally, you should have money in four buckets: tax-deferred accounts, Roth accounts, regular investments, and fixed income sources. Each of these different types of retirement income sources have different income tax implications. By strategically adjusting how much you withdraw from each of these different sources every year, you can keep your income taxes to a minimum. In a year during your retirement when you have a lot of expenses (for example, buying a vacation home), you can withdraw more from your tax-free Roth IRA and avoid having a high taxable income that year. In a year in retirement when you do not have a lot of expenses, you can leave your Roth IRA alone and instead withdraw from your tax-deferred retirement accounts. Your retirement portfolio withdrawal strategy should be based on minimizing taxes over your lifetime and that strategy requires having the flexibility of a diversified portfolio. For this reason, I believe that everyone needs a Roth IRA (or Roth 401k or Roth 403b). The challenge is determining when is the best time to put money into that Roth IRA. For many people, putting money into a Roth IRA by contributions or conversions after age 65 can make sense.
January 15, 2024