Money Basics

Roth retirement account rules can be confusing, which may be why I get many questions about them from Money Girl readers and podcast listeners. While there's a sea of regulations to navigate, it's worth learning them so you can reap the benefits, such as paying lower taxes having withdrawal flexibility. 

Today, I'll answer four questions and review five critical rules for using a Roth account at work or on your own successfully.

Before we get into the details on crucial Roth rules you should know, let's answer a voicemail I received from Chris, who didn't want to be on the air. She says:

I just recently started listening to your podcast, and I really enjoy it. What are the benefits of an IRA versus saving your money in a savings account or CD?

Thanks, Chris! That's a terrific question about an important topic.

What are the benefits of using a retirement account?

There are several reasons why using a retirement account for long-term savings is critical. First, retirement plans, such as a traditional IRA, traditional 401(k), and SEP-IR, allow owners to make tax-deductible contributions if they meet specific requirements. That cuts your taxes in the current year, saving you money.

For example, if you earn $60,000 and contribute $5,000 to a traditional IRA or workplace 401(k), you pay income tax on just $55,0000, not $60,000. When you retire and take distributions, Uncle Sam catches up with you by imposing income tax on amounts you withdraw.

Roth retirement accounts, such as a Roth IRA, Roth 401(k), or Roth solo 401(k), have the opposite taxation as traditional accounts. Contributions to any Roth get taxed the year you make them. However, your future withdrawals of contributions and earnings are entirely tax-free if you meet specific rules, which we'll cover.

If you invest for decades and your Roth account mushrooms in value, it's nice to know that you'll never have to pay income tax on your earnings. And if income tax rates increase down the road, that could make having a Roth especially sweet.

If you invest for decades and your Roth account mushrooms in value, it's nice to know that you'll never have to pay income tax on your earnings. And if income tax rates increase down the road, that could make having a Roth especially sweet.

Additionally, retirement accounts allow you to select investments for your contributions, such as mutual funds and exchange-traded funds. They bundle hundreds or thousands of underlying securities, such as stocks, bonds, currencies, and real estate, which gives you diversification and reduced risk.

The growth you achieve within a retirement account depends on the investments you choose but could easily blow the doors off a high-yield savings account or certificate of deposit (CD). It's not difficult to get an average annual return of 5% to 8% through investment funds. You'd be hard-pressed right now to find a CD or bank account paying more than 1%.

If you saved $200 a month for 40 years in bank savings account paying an average of 0.5%, you'd have slightly more than $106,000. But if you invested $200 a month for 40 years in a retirement account with funds paying an average of 7%, you'd have $528,000. 

With savings, you're not even keeping up with inflation, which was historically low in 2021 at 1.25%. You need investment growth to reach big financial goals like retirement. Otherwise, you aren't likely to end up with enough to have a comfortable lifestyle down the road.

Five rules to know about Roth retirement accounts

Now that you understand why retirement accounts are critical for building long-term wealth let's cover five rules you should know about Roth accounts, including the answers to more listener questions.

1. You can withdraw original Roth contributions without penalty

Besides tax-free income in retirement, one of the best parts about having a Roth is the ability to tap it before retirement without paying an early withdrawal penalty. With other types of retirement accounts, you must reach age 59½ before withdrawals are penalty-free. But note that this only applies to your original Roth contributions. That's because you pay tax upfront on that portion of funds in your account. 

Having the flexibility to tap contributions is why a Roth is an excellent choice for non-retirement goals such as paying for college, buying a home, or starting a business.

Having the flexibility to tap contributions is why a Roth is an excellent choice for non-retirement goals such as paying for college, buying a home, or starting a business. That's important to Diane K., who says:

I just discovered your podcast and love it! I'm a recent college graduate and plan to work and save money before returning to graduate school. What's the best account to use if I don't have a ton of time and need flexibility if I change my mind?

Thanks for your question, Diane. Using a 529 college savings plan is a tax-advantaged account that allows you to save high amounts and offer additional benefits. However, you can only spend the funds on qualified education expenses. So, if you're not 100% sure that you'd use the money for graduate school, consider using a Roth IRA instead. 

One unique rule of using a Roth IRA is that your income can't exceed an annual threshold. Keep reading to learn more.

2. You must own a Roth for five years to withdraw earnings tax-free

If you want to withdraw the earnings portion from a Roth, there are some fundamental rules to know. If you're younger than 59½, you must pay income tax plus an additional 10% early withdrawal penalty on them. Also, even if you're older than 59½, you must have owned your Roth for at least five years for an earnings withdrawal to be penalty-free

3. Roth rollovers don't change the five-year rule

Debra H. asks a question about doing a rollover from a workplace plan to an IRA. She says:

I really enjoy learning about retirement topics on your podcasts. Would you please explain how the 5-year rule applies to transferring a Roth 401(k) to a Roth IRA in an upcoming podcast? Thanks for the valuable information you provide.

Thank you for being a podcast listener, Debra! Doing a rollover is an excellent option after you leave an employer for any reason. Once you're no longer employed, you can transfer funds from a Roth 401(k) into a Roth IRA without triggering any tax consequences.

But what can trip you up is not understanding that the five-year rule applies to the account receiving the rollover funds, not the old account. In other words, if you open a brand-new Roth IRA to accommodate your rollover, you're at day one of the five-year holding period—even if you made contributions to the old Roth 401(k) for decades.

However, if you already have a Roth IRA and use it for a rollover from a Roth account at work, its age counts toward the holding period. So, if it's three years old, you'd have to wait two more years to pass the ownership test for taking penalty-free withdrawals. And if you've already owned a Roth IRA for five years and use it for a rollover, you pass the ownership test.

So, if you have a Roth 401(k) or Roth 403(b) and don't already have a Roth IRA, go ahead and open one. That will start the clock ticking and reduce the likelihood that you'd ever get held up by a waiting period.

So, if you have a Roth 401(k) or Roth 403(b) and don't already have a Roth IRA, go ahead and open one. That will start the clock ticking and reduce the likelihood that you'd ever get held up by a waiting period. Otherwise, you could be over 59½ and still not qualify to withdraw the earnings portion of your Roth IRA without paying an additional 10% penalty.

When you're ready to open a Roth IRA, it's as easy as opening a bank account. You complete an application and transfer funds to activate the account. Look for a company that offers the kinds of retirement investments you want to make, offers free investment advice, and gives you simple options, such as Betterment.

The minimum amount you need to open an IRA is typically small, such as $50 or $100. Once it's open and funded, you don't have to put in another penny. Simply having a Roth IRA in your name counts toward the five-year requirement. Now, if you lose your job or decide to leave your employer, you can roll over Roth funds into an already-established Roth IRA.

For a summary of rules for using different retirement accounts, download the free Retirement Account Comparison Chart. This handy resource spells out everything you need to know on a one-page PDF.

4. Roth accounts at work don't have income limits

A workplace Roth and a Roth IRA are very similar; however, there are some significant differences to know. First, anyone with income can use a Roth IRA. But you can only have a Roth 401(k) or a Roth 403(b) if your employer offers it.

David R. is also interested in learning more about Roth accounts. He says:

My employer offers a Roth 401(k) option, but I don't think I qualify due to my income. I like the idea of paying tax for my contributions now. Can you explain if there's a way for me to participate?

Thanks for your question, David! An often-overlooked benefit of having a Roth workplace plan or a Roth solo 401(k) is that there are no annual income limits to qualify. If you're eligible for a Roth 401(k) at work or have a Roth for the self-employed, you can contribute no matter how much money you make.

An often-overlooked benefit of having a Roth workplace plan or a Roth solo 401(k) is that there are no annual income limits to qualify.

So, the answer to David's question is that he qualifies for his Roth 401(k). He could contribute solely to the Roth 401(k) or split contributions between the Roth and his traditional 401(k).

For 2020, here are the income limits to qualify for a Roth IRA:

• If you file taxes as a single and your modified adjusted gross income is $139,000 or higher, you cannot contribute to a Roth IRA. 
• If you're married and file taxes jointly, you cannot contribute to a Roth IRA when your household's joint modified adjusted gross income is $206,000 or higher. 

For 2021, the income limits are slightly higher:

• If you file taxes as a single and your modified adjusted gross income is $140,000 or higher, you cannot contribute to a Roth IRA. 
• If you're married and file taxes jointly, you cannot contribute to a Roth IRA when your household's joint modified adjusted gross income is $208,000 or higher. 

If you're married and file taxes separately for either year, you're unable to contribute to a Roth IRA when your modified adjusted gross income is $10,000 or higher.

RELATED: 10 Simple Reasons to Invest in a Roth IRA or Roth 401(k)

5. You can have multiple retirement accounts

Having a Roth IRA or a Roth at work is terrific—but don't stop there. You can easily pair them with other Roth or traditional accounts if you don't exceed the total annual contribution limits.

For 2021, you can contribute up to $19,500, or $26,000 if you're over age 50, to a workplace retirement plan. The annual contribution limit is lower for a traditional or Roth IRA: $6,000 or $7,000 if you're over 50.

For example, you can max out a Roth 401(k) at work and contribute the maximum amount to a Roth IRA or a traditional IRA. You can also split your contributions between traditional and Roth accounts in any proportion you like.

For instance, you could contribute $10,000 to a traditional 401(k) and $9,500 to a Roth 401(k). Or you could contribute $3,000 to a traditional IRA and $3,000 to a Roth IRA if you're under age 50 and don't earn too much for a Roth IRA.

Depending on your income, your tax deduction for a traditional IRA may get reduced or eliminated when you or a spouse also have a traditional workplace retirement plan. But no matter your income, you can still contribute to a traditional IRA. 

With a Roth IRA, there's no conflict because your contributions are not tax-deductible. So, as long as you don't earn too much to contribute to a Roth IRA in the first place, you can max out both a Roth IRA and a workplace retirement plan every year and get 100% of the tax benefit.

Alissa B. has an interesting question about using multiple retirement accounts. She says:

I've been enjoying your podcast for several weeks. Thank you, it's a great resource. I have three retirement accounts, an annuity from a previous job, a Roth IRA, and a traditional IRA. To maximize compounding, does it make sense to contribute only to the highest-value account?

Thanks, so much Alisa–I'm happy you found the Money Girl podcast! When choosing which account to use, the best strategy is to fund the one that will give you the best tax benefit. If you need a tax break in the current year, the traditional IRA will help. Otherwise, I recommend maxing out your Roth IRA first unless you become a high earner and don't qualify.

With a Roth, you get the most potential future tax savings. As I mentioned, when you take Roth withdrawals in retirement, they're entirely tax-free, which could save you much more in the long run compared to your traditional IRA.