Welcome to The Wealthy Mom MD Podcast—a podcast for women physicians who want to learn how to live a wealthy life. In this podcast, you will learn how to make money work for you, how you can have more of it, and learn the tools to empower you to live a life on purpose. Get ready to uplevel your money and your life. I'm your host, Dr. Bonnie Koo.
Welcome back. So today I want to tackle the Roth IRA and all things that have the name Roth in it. So things like Roth conversions, the mega backdoor, Roth, IRA, the Roth, 401k, et cetera. I see a lot of confusion around this, but it's actually quite simple. So by the end of this episode, my goal is for you to walk away understanding anything that has the word Roth in it when it comes to retirement accounts, right?
First, we need a brief history lesson because the word Roth comes from someone's name, and his name is William Roth. He's no longer with us. He was a United States Senator and representative for Delaware. He is the one who is credited for creating the Roth IRA for Americans in 1997. Before that, it didn't exist.
I'm going to start this conversation discussing the Roth IRA because everything else that has the word Roth is based off the Roth IRA. And once you understand what the concept of Roth means in terms of money and retirement accounts, I'll go over the rest of it and you can see how it applies easily to those types of accounts.
First, let's just briefly define IRA. It stands for individual retirement accounts. There are several types. I'm not going to go over all of them right now, but simply know that an IRA is one of the tax advantaged retirement accounts owned by individuals like the name says. So let's break that apart a little bit more. Tax advantaged--all that means is there some sort of tax advantage for the account at some point, and we'll go over that. Owned by the individual means, well, like it says, meaning I can own an IRA. There's no such thing as a joint IRA if you're married, because like the name says, it's owned by an individual.
So what's the tax advantage for a Roth IRA? This is what makes the Roth special because of its unique tax advantages compared to other types of retirement accounts. Here's the deal. You contribute after tax money to a Roth IRA. What this means is you earn income and pay taxes on that income, right? So simply, if you're a W2 employee, right, your taxes are taken out of your paycheck and then you get what's left over. Right? So that's what I mean. You're using money that you earn, money that's already been taxed. So you put that money inside of a Roth IRA. It's been taxed already, right? Because you paid income taxes. You invest the money inside the Roth IRA and those investments grow tax free. When you go to withdraw the money that's been invested and growing, that money is tax-free. So basically you only pay taxes once. And that is kind of the case for all retirement accounts. You pay taxes at one time. It's just a matter of when you pay the taxes, right? So basically for a Roth IRA, you pay the taxes upfront because you've paid income taxes and then you never pay taxes again on that amount of money.
Let's just go over those steps again, right? So there's three steps. Basically the money you contribute to the Roth IRA, that's already been taxed, the money inside of it as it grows. And it grows because you're investing the money by buying assets like stocks, bonds, index funds, you can even buy real estate, and then you take the money out. That's step three and you don't pay taxes on that. These three steps apply to all retirement accounts by the way. And I like to think of it as that framework of the money you put in the money that grows inside and the money is taken out.
When do you pay taxes? You'll notice that pretty much for every retirement account, you'll pay taxes at some point; the only account that you never pay taxes ever is the health savings account or HSA. You may have heard that account being called a triple tax free account. And it's the only one like that. So for the Roth, except for the money you put into it, that's been taxed. Everything else is tax-free. So that's the overall framework of the Roth IRA. Now that sounds pretty simple, right? You just pay taxes in the beginning and you never pay taxes again. That's the Roth concept.
Now let's go into the fine print because there is fine print of course. How do you actually open this? You open the account yourself, right? Because an IRA means that you own it. Not someone else, not together with your spouse. So you open it at a custodian. A custodian just means a financial institution. So you can think of it as a bank basically, but not like the bank that you put your checking account, generally speaking, and only you own it.
There are contribution limits, like almost all retirement accounts, right? So in 2020, the annual contribution limit is $6,000. If you're age 50 or higher, it's higher, it's $7,000. And if you're 50 and over, you generally have higher limits for most other types of retirement accounts, not just a Roth IRA. Now these annual limits change almost annually to keep up with inflation.
So then the next thing is, well, what is the annual contribution in terms of the calendar year? So the contributions are by calendar year. So let's just talk about 2020. So when you contribute a Roth IRA, you contribute for a year, but the deadline to contribute is tax day of the following calendar year. Let's just use dates. It's much easier to explain it this way. If I'm contributing to my 2020 Roth IRA, I have until April 2021 to actually put it into the 2020 IRA. Now, I'm recording this in spring of 2020, and we are still in the middle of the COVID pandemic. So some modifications have been made for these contribution limits for the contribution limit deadline. But generally speaking, the rules are that you have until April tax day of the following calendar year.
There's also an income limit, meaning that if you make over a certain amount, which in 2020 is $124,000, if you're single, then you start getting phased out. What that means is after you hit the upper limit, which is $137,000 for a single person in 2020, you cannot contribute to a Roth IRA directly. More on that later, because many of you are like, “But I make more than that!” So you can contribute, just not directly. You may have heard about the backdoor Roth. I'll talk about that a little bit later, okay?
A few more rules stay with me. You need to have earned income to contribute to a Roth IRA, meaning you need to work. You need to have earned income from a job or a business. So you can't just use money gifted to you or gifted to your kids to open a Roth IRA. Yes, your kids can open a Roth IRA, but they need to have earned income and things like, you know, household chores do not count for that. If you are married, you don't have to have earned income, but your spouse has to have earned income. And if you're married, you can open what they call a spousal Roth IRA. Now, it's the same exact process to opening a Roth IRA. You just have to mark saying that you fulfill the rules for opening and contributing a Roth IRA. Like no one's checking on you unless you get audited.
So what are the rules for taking the money out? As you probably know, there are lots of rules around how you can take your money out of retirement accounts, like your 401k or 403b. And you're probably aware that these rules are somewhat restrictive. In fact, some of us call these accounts Money Jail. It's your money, but there's so many rules about how you can use and take it out. And there's penalties if you take it out too early. Well, the Roth IRA has probably the most lenient rules compared to all other retirement accounts. Now I'm not talking about a regular brokerage account or taxable account, which is not a “traditional retirement account.”
For the Roth IRA, you are allowed to take out original contributions, also called principal, at any time without penalty. So for example, if you do your $6,000 contribution, and let's say five years later, it grew to $10,000 because you invested in it. I'm not talking about additional contributions for this example, you can take out that original $6,000 without penalty at any time. Because you remember you already paid taxes on this money before you contributed. So there's no tax issue by removing it. If you want to say, take out the $10,000, which is the original $6,000 you put in plus $4,000 of investment gains, then there are some rules about taking out those investment gains. There is what they call a five year waiting period. And if you don't wait at least five years to take out that $4,000 of gains, you will pay a penalty. Now, I know we're getting into some of, into the weeds here, right? But hopefully none of you will have to really think about taking money out early.
The last fine print thing I want to go over is that Roth IRAs have no required minimum distributions (RMDs). What the heck is that? This is just another rule around most retirement accounts. Think about the name: required minimum distributions. It's basically what it sounds like. The government makes you take out a minimum distribution from retirement accounts starting at age 70.5. These RMDs--like the amount that you have to take out--depend on your age and your sex. Right? It’s based on sort of accuracy curves. If you don't take out a certain amount of money, if you don't take out this minimum distribution, then you pay a penalty. Okay? So basically bottom line, once you reach 70.5, for many types of retirement accounts, you have to take out a certain amount of money every year, or you start paying penalties. But with the Roth IRA, there's no such thing.
I know that was a lot of fine print. So let's just review the basics again. The Roth IRA is all about using after-tax money for contributions, and then you never pay taxes again. That is the hallmark of the Roth. IRA. You contribute after tax money to contribute to a Roth IRA, meaning you already paid income taxes on it. The money inside of a Roth IRA, when you're investing it, grows tax free. This is pretty common to all retirement accounts, by the way. When you withdraw the money from a Roth IRA, it's tax-free because you already paid taxes on it and it grows tax free inside. You can take out your original contributions, also called principal, at any time. But if you want to also take out some of the gains, you have to wait at least five years. After tax money goes in, never pay taxes again, and much more flexible rules on taking your money out. Got it? Okay.
Let's now talk about the backdoor Roth IRA. This is not the official name by the way for this process, but that's sort of what many of us call it. The official sort of name of the process is basically you’re indirectly contributing to a Roth IRA when your income is over the annual income limits. And yes, it is a hundred percent legal. Here are the two steps. Number one is you contribute to a traditional IRA and step two, you convert it to a Roth IRA. That's really it.
I'm going to break them down further and there are some caveats, but really the process is that simple. You contribute to a traditional IRA and step two is you convert it to a Roth IRA. I know it sounds super silly. Like why can't you just do it the normal way? But this is just the way it is in terms of the legal Ines.
Okay. So first we need to make sure that you can do this. So then you might ask, “Okay, why wouldn't I be able to do this?” Well, if you have any other accounts that are IRAs, for example, a lot of us will move jobs. We will end up taking that old employer account where 401k or 403b, and rolling it over into an IRA. These are called rollover IRAs, or maybe you own a business or you have contractor income and you've opened a SEP IRA. So if you have any other IRA accounts, it's not that you can't do this process. It's just that you're going to pay some extra taxes. And this is called the pro-rata rule.
Now this is where people get lost in the weeds. The bottom line is if you have any other IRAs that have a non zero balance. So just because you have it, it doesn't mean that you can't do it. It is just that if you have other IRAs and the balance is not zero, meaning there's money in it, you're going to run into some tax trouble. So yes, you can do it. It's just not a good idea because you're going to pay taxes on even contributing to it. And that kind of defeats the purpose of the IRA. So if you're in that category, if you're someone who has a SEP IRA for someone who has a rollover IRA, all you need to do is zero out those accounts.
And there's many ways to do this. You can open a solo 401k and move all that money in, or you can move the money into your current employer account. Where I see most people getting confused around the backdoor Roth IRA or freaked out by this is. That is in the first step, putting that $6,000, which is a 2020 contribution limit into a traditional IRA. So a traditional IRA is the IRA that any of us can open up at any time. There is an annual contribution limit. It's the same exact limit as the Roth IRA, maybe to take a step back for a second. IRAs come in two flavors pretax and after tax. Now, since you are an expert in a Roth IRA, you probably can guess that you need to choose the after tax traditional IRA.
Okay? So you contribute to a traditional IRA. Let's use Vanguard as an example. That's where my Roth IRA is. You literally open an account and you choose traditional IRA and you contribute to that account. Now, places like Vanguard, make it super easy to do a Roth IRA conversion from a traditional IRA. They literally have a button that says convert to Roth IRA. Many of the popular custodians have made it this easy for you, but technically you need to also open a Roth IRA account. So now you might be thinking, “Okay, but now I have two accounts with an IRA. You just told me that I can't do that.” I said that you can't have one with a nonzero balance because once you convert it, meaning move the traditional IRA into the Roth IRA, that traditional IRA becomes zero. Do you see what I'm saying?
That's honestly the whole process, but people still get confused because there are some caveats. Anytime you have any sort of IRA, there is a form you have to fill out with the IRS with your taxes. It's Form 8606. It's just one of those forms. You have to fill out if you have an IRA, but it has to be filled correctly. If you do this backdoor Roth and some accountants don't do it correctly. If you're someone who does your own taxes, you need to make sure you fill this out correctly. IRS will want you to pay taxes. And this is not a “taxable event.” When you do these Roth conversions to move from a traditional IRA to a Roth IRA, we are doing this online. For example, you might get a warning that says, this is a taxable event because here's the thing. Vanguard doesn't know what you're actually doing with the money. You know, they don't know if the money's been taxed already. So they have to put this warning up. If you follow the steps I went over, meaning you're putting after tax money into a traditional IRA and then clicking that convert to Roth IRA, it’s not a taxable event. I will link in the show notes to a step by step guide and how to do this, including how to fill out Form 8606 in the show notes.
Now, I want to talk about some of the other types of things that have the word Roth in it. First, I want to tackle the term Roth conversions. Now, this is confusing because I used the word convert when I was talking about the backdoor Roth IRA. This is a different type of conversion. Simply put, a Roth conversion refers to moving pre-tax retirement accounts into a Roth IRA. Take a step back for a second. If you remember for the Roth IRA, you put in after-tax money. So if you have pre-tax retirement accounts, meaning that you didn't pay income taxes when you contributed to the account, and you want to move that into a Roth IRA, you're going to have to pay some taxes on that. That makes sense. Right? So all a Roth conversion means is that you're converting a pretax retirement account to a Roth IRA. So you will have to pay taxes in order to do that at your current marginal tax rate on conversion. The key is to time these conversions in low income years, such as the year you stop working. Roth conversions are actually quite common, or I should say a common strategy, for people retiring or in their early retirement years to take advantage of their lower income tax bracket. For most of us, this is not something we're going to think about right now, but it is something to think about when you have a lower income tax year and want to take advantage of that.
Now let's talk about Roth 401ks. Most of us have access to a 401k or 403b, if we're employed. Most are traditional, which means pretax, which means the contributions reduce our taxable income by the amount we contribute. And these accounts grow tax free and we pay income taxes when we take the money out in retirement. But many plans will offer a Roth option, meaning that you have a Roth 401k. I see people getting confused because they confuse the Roth 401k with the Roth IRA in terms of, you know, contributing to it or being over the income limit. The Roth 401k has nothing to do with the Roth IRA.
The only thing it means is that you contribute after tax dollars that grow tax free and that are tax free on withdrawal. Hm, kinda sounds like the Roth IRA, but just called a Roth 401k. What I call the signature Roth tax treatment within a 401k. It's basically the same in terms of the fine print even, except for the required minimum contributions. That means that Roth 401kss are subject to RMDs, but you can actually get around this by converting the Roth 401k into a Roth IRA. Because the Roth 401k, you already paid taxes on the contribution, there are no tax consequences for this type of rollover.
Now, many people ask if they should use the Roth option or the pre-tax option. You know, it really depends. I will say that in general, I favor the pretax or traditional option for people in high marginal tax brackets or in high income tax states, such as New York or California. Otherwise, you definitely want to consider the Roth option or go 50/50.
One more big topic to tackle in this Roth umbrella is the mega backdoor Roth IRA. Now that's not an official name. What is this mega backdoor Roth IRA? It is the ability to contribute an additional $36,000 a year into a Roth IRA. Remember, way early on, I said, at least in 2020, the contribution limit to a Roth IRA is $6,000. So how can you contribute an additional $36,000? That's why this is called the mega backdoor Roth IRA. All right. So we've come to the end of this episode and I hope your head isn't spinning.
I'm going to summarize what we just went over. Remember when you contribute to a Roth IRA, you're using money that's already been taxed, or after-tax money. When you invest the money and the money grows, that growth is tax free. When you take the money out of a Roth IRA, it's tax free. So remember there's three steps. The money you contribute, the money inside that grows because you're investing it, and three, the money you take out. This applies to all retirement accounts, by the way, this framework. So for the Roth, except for the money you put into it, everything else is tax-free. So you just need to use after-tax money to get a Roth IRA going. The one Roth thing I didn't talk about this episode is the mega backdoor Roth IRA, and I'll save that for another episode.
I'll see you next time.
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