Wednesday Jul 24th, 2024

All about Traditional IRAs and Roth IRAs

Contributing to an IRA (Individual Retirement Account) is a great way to save for retirement because of the wonderful tax benefits you get from these types of accounts. You can contribute to your IRA if you have earned income (or are married to someone with earned income), and it’s a really great idea to do so if you don’t have access to a 401k, 403b or other type of retirement plan through your employer. However, if you do have access to a 401k, contributing to an IRA may make sense to supplement the 401k and further beef up your retirement savings.

2024 Contribution Limits for Traditional IRAs

  • IRA/Roth IRA contribution limit: $7,000 per year
  • IRA/Roth IRA - catchup contribution limit: $8,000 per year if you are over the age of 50.

These limits are for 2024 and they typically increase a little every calendar year. Whether you contribute to a traditional IRA, a Roth IRA—or both—these limits apply to the combined traditional and Roth contribution amounts each year. 

 

Tax Implications of Traditional IRAs vs. Roth IRAs

With traditional IRAs, you get a tax deduction in the year you contribute. In other words, if your taxable income would normally be $100,000, and you contribute $7,000 to a traditional IRA, then your taxable income becomes $93,000 in that tax year. The money grows tax-free and then is taxed when you withdraw the money in retirement. 

With Roth IRA contributions, you don’t get a tax deduction in the year you contribute. So if your taxable income would normally be $100,000 in a given year, and you contribute $7,000 to your Roth IRA, then your taxable income is still $100,000. However, the funds grow tax-free, and you never have to pay taxes on that money again when you withdraw the money in retirement. 

So, Should I Contribute to a Traditional IRA or Roth IRA?

If you expect to be in a higher tax bracket now than in retirement, you’re better off making traditional IRA contributions. That way, you get the tax deduction now and pay taxes at a presumably lower rate when you withdraw the funds in retirement. 

Conversely, if you expect your tax bracket to be higher in retirement than it is now, you are better off making Roth IRA contributions. That way, you are effectively paying taxes now on this money by not taking the tax deduction. When you get to retirement—and are presumably in a higher tax bracket—you won’t be paying the taxes on the money when you withdraw the funds.

The conventional thinking is that most people will be in a lower tax bracket in retirement than they are now, so it makes more sense for most people to make traditional IRA contributions rather than Roth contributions. 

However, my view is that it is a lot more complicated than this. Many people (myself included) believe that taxes overall will be higher in the future. That is, the current tax rates we’re paying will increase. So even if you expect your income to be lower in retirement (at least relative to inflation), your marginal tax rate may still be higher in retirement than it is today. 

I take every client’s individual situation into account when guiding them on whether to make Roth or traditional IRA and/or 401k contributions. This article can serve as good general guidance, but each situation is different depending on your individual circumstances. 

 

Income Limits for Traditional IRA and Roth IRA Contributions

If you make over a certain amount of money, then you cannot get a tax deduction for contributing to a traditional IRA. This amount changes each year in line with inflation. 

For 2024, you cannot get a tax deduction for traditional IRA contributions if your income is more than $87,000 if single, or more than $143,000 if married filing jointly. 

If you can’t get the tax deduction for contributing to your traditional IRA due to your level of income, then it makes sense to instead contribute to a Roth IRA. In this case, the tax benefit of contributing to your traditional IRA would be moot. So that tax benefit being equal, the difference would come down to taxes upon withdrawal. For the traditional IRA, you would have to pay taxes on all of the growth when you withdraw it in retirement, whereas the Roth IRA would be tax-free withdrawals. 

The problem, however, is that if your income is over a certain amount ($146,000 if single, $230,000 if married filing joint), your ability to contribute to a Roth IRA is limited. You are completely ineligible to contribute to a Roth if you earn over $161,000 if single, $240,000 if married filing joint.

 

Understanding Roth conversions

Anyone who has traditional IRA assets may do “Roth conversions” on some or all of their traditional IRA balances. This means they can move money from their traditional IRAs to Roth IRAs and pay taxes on the amount of the conversion. 

In other words, if you have, say, $20,000 in a traditional IRA and want to convert the entire account to a Roth, then you would open up a Roth IRA (if you don’t already have a Roth IRA account). Then you would transfer the funds from the traditional IRA to the Roth IRA. You would then have an additional $20,000 of taxable income, beyond your regular income, in the year of the conversion. 

This conversion may make sense to do if you find yourself having a tax year of unusually low income. But you’d need to weigh the overall pros and cons of how you’d use the money related to the conversion. Do you want to pay the taxes on this conversion? Or do you want to take that conversion tax money and invest it instead? 

Regardless, the key here is that anyone, regardless of their income, can convert traditional IRA to Roth IRA money if they so choose.

 

Where the backdoor Roth comes into play

Backdoor Roths are a great way to effectively contribute to a Roth IRA, even if you make too much money to directly contribute to a Roth IRA. 

Here’s how it works. You would first open up both a traditional and a Roth IRA account. You would contribute up to the maximum to your traditional IRA ($7,000 if under the age of 50, $8,000 if over the age of 50). Right away, you would convert this balance to your Roth IRA. Be sure to invest the money once the funds land in your Roth IRA so that the money will grow!

RESOURCE: CAN I DO A BACKDOOR ROTH CONTRIBUTION - 2024 [DOWNLOAD]

While you don’t get the tax deduction for contributing to your traditional IRA, this also means that the Roth conversion is not a taxable event! Repeat this again every year. While the maximum amount you can contribute each year may seem small, continual annual contributions plus compounding growth of the assets will, over time, provide you with quite a sizable Roth IRA account–money that will never be taxed! 

Understanding the pro-rata rule

The key to doing backdoor Roths is NOT having any traditional IRA assets to begin with. Otherwise, the Roth conversion piece will be at least partially taxable. If you have money in a traditional IRA, then the IRS does not view you as converting just the $7,000 that you contributed to the traditional IRA in that given tax year. They view you as converting $7,000 out of your total traditional IRA balance and will tax you on the pro-rata amount that you convert. You can’t get around this by simply opening up a new traditional IRA. The IRS looks at all traditional IRA assets that you have, including SEP IRAs by the way. 

For example, if you have $7,000 in a traditional IRA from a 401k rollover and/or prior year IRA contributions, you contribute $7,000 in the current tax year for your backdoor Roth, and then convert $7,000, you will be taxed on 50% of the conversion ($7,000 out of the total $14,000 balance). So $3,500 of your $7,000 conversion will be considered taxable. This does not necessarily mean you shouldn’t do backdoor Roths if you have traditional IRA money already, but it’s not a no-brainer. You should talk to your financial advisor and weigh the pros and cons of doing so.

 

Avoiding the Pro-Rate Rule when You Have Traditional IRA Assets

If you do have traditional IRA assets, you may be able to get around the pro-rata rule. If your entire traditional IRA balance came from rolling over a 401k, 403b, or other employer-sponsored retirement plan, and you made no direct contributions to the IRA, you may be able to roll the IRA into your current company’s 401k or 403b plan (if your current plan allows, and the vast majority of them do).

Having traditional 401k and 403b funds does NOT trigger the pro-rata rule. So if you are eligible and able to roll your traditional IRA assets into your current employer plan, this is often a great thing to do. That way, you can start doing non-taxable backdoor Roth contributions.

Do note that before rolling any IRA assets into your 401k or 403b, you will want to review the fees and investment options associated with your employer-sponsored retirement plan and weigh the pros and cons of doing so. Ask your financial advisor for their assistance on it. It can be tricky to dig through all of the documents, find all of the necessary information, and then make sense of it all if you don’t have experience doing this. 

Are backdoor Roths confusing? Yes, they are! Many clients have asked me why they have to jump through so many hoops to get money into a Roth IRA, and it’s a fair question. The answer is that the IRS rules don’t always make sense, so if you’re trying to make logic of all of this, you may not be able to. Nevertheless, once you get used to doing your annual backdoor Roth contributions, you’ll get the hang of it and no doubt find it well worth your while.

 

About the Author

Carla Adams is a CERTIFIED FINANCIAL PLANNER™ practitioner who specializes in helping women build strong financial plans around their equity compensation, including Restricted Stock Units (RSUs) and company stock options. With over 15 years of experience in financial services, Carla has in-depth knowledge and expertise geared toward helping clients with complex financial situations. She enjoys boiling down complicated scenarios through practical examples and down-to-earth conversations.