Retirement savers understand the importance of being proactive. Having healthy retirement savings can help you live comfortably in your later years. As stewards of our clients’ wealth, we take great satisfaction in helping them prepare for retirement. We also enjoy assisting parents and grandparents who wish to contribute to their loved ones’ future by properly gifting funds to a retirement account, provided the recipient has earned income and qualifications. Funding retirement accounts at younger ages can significantly improve the chances of enjoying a comfortable financial situation during retirement.
Traditional IRAS
A traditional IRA (Individual Retirement Account) is a way in which individuals can save for retirement and receive tax advantages. Traditional IRAs come in two varieties: deductible and nondeductible. Contributions to a traditional IRA may be fully or partially deductible, depending on your circumstances (i.e., taxpayer’s income, tax-filing status and other factors) and generally, amounts in a traditional IRA (including earnings and gains) are not taxed until distribution.
A key advantage of a traditional IRA is that contributions may be tax-deductible, potentially lowering your taxable income in the year they are made. Like Roth IRAs, investments within a traditional IRA grow tax-deferred, meaning dividends, interest, and capital gains aren’t taxed annually. This tax-deferred structure may allow your investments to compound more effectively over time compared to a taxable account.
Roth IRAS
A Roth IRA is an IRA that is subject to many of the same rules that apply to a traditional IRA with some major exceptions. Unlike traditional IRAs which can be tax-deductible, you cannot deduct contributions to a Roth IRA.
Some Roth IRA advantages include:
- If you satisfy certain requirements, qualified distributions can be tax-free.
- You can leave funds in your Roth IRA for your entire lifetime.
- Beneficiaries inherit your Roth IRAs tax-free, if account requirements have been satisfied.
Many investors know and understand that the largest benefit of the Roth IRA is its tax-free withdrawal of contributions, interest and earnings in retirement, but Roth IRAs can also be a powerful part of good estate planning.
Spousal IRA
If your spouse does not work, they can still fund a spousal traditional or Roth IRA. This allows non-wage-earning spouses to contribute to their own traditional or Roth IRA, provided the other spouse is working and has enough taxable income to cover the contributions in addition the couple files a joint federal income tax return. If the working spouse is covered by a retirement plan at work, deductibility of contributions to a spousal traditional IRA would be phased out at higher incomes. Eligible married spouses can each contribute up to the contribution limit each year to their respective IRAs (spousal IRAs are also eligible for a $1,000 catch-up contribution for those 50 and older).
Custodial Roth and Traditional IRAs
Starting retirement savings early can allow the potential advantage of growing money in a tax efficient account over a long period of time. Many children work before age 18. Earned income makes them eligible to contribute to a IRA, which can be a smart move for teenagers. This can also provide an excellent opportunity to teach or reinforce the importance of saving money.
Some of the rules regarding custodial IRAs are:
- To be eligible to open a custodial IRA, the child must meet all the same requirements as an adult. The minors must have earned income and contributions are limited to the lesser of total income earned for the year and the current maximum set by law, which for 2025 is $7,000.
- The IRA must be managed for the benefit of the minor child.
- As the custodian, you make the decisions on investment choices—as well as decisions on if, why, and when the money might be withdrawn—until your child reaches “adulthood,” defined by age (usually between 18 and 21, depending on your state of residence). Once they reach that age, the account will then need to be re-registered in their name and it becomes an ordinary IRA.
If you are the parent of a child who has earned income, a Custodial IRA can be a great way to teach the value of saving and investing. Besides getting a start on saving, your child may be able to use the funds for college expenses—or even to buy a first home.
There are several ways to fund a Custodial IRA. For example, you can potentially use your annual ability to give gifts to children or grandchildren to make this happen.
What is a Rollover IRA?
A Rollover IRA is a type of Individual Retirement Account that allows you to transfer funds from your former employer’s retirement plan, such as 401(k)without incurring taxes or penalties. This process facilitates the continuation of tax-deferred growth of your retirement savings. The one reason to consider a rollover IRA could be to provide more investment flexibility and greater control over your retirement funds.
The Mechanics of Rollover IRAs
When you leave an employer, whether due to retirement or a job change, you have several options for handling the funds in your employer-sponsored retirement plan. One of the most advantageous options is transferring these funds into a rollover IRA. This not only preserves the tax-advantaged status of your savings but also could open a broader range of investment opportunities.
Why Consider a Rollover IRA?
Rolling over your retirement plan to an IRA can offer several benefits, such as broader investment choices, continued tax-deferred growth, and potentially lower fees. However, it’s also important to consider the potential drawbacks. You may lose certain protections offered by employer-sponsored plans, such as access to loan options or stronger creditor protections. Understanding both the advantages and limitations of a rollover IRA is essential to making an informed decision that supports your long-term retirement goals.
Enhanced Investment Choices
Unlike a traditional 401(k), which may offer limited investment options, a rollover IRA provides access to a virtually unlimited array of investment vehicles. This includes stocks, bonds, mutual funds, ETFs, and more. Such diversity could allow you to tailor your portfolio to better align with your risk tolerance and retirement goals.
Consolidation of Retirement Accounts
Managing multiple retirement accounts can be cumbersome and confusing. A rollover IRA allows you to consolidate your retirement savings into a single account, simplifying your financial management and potentially reducing fees.
Continued Tax Advantages
Funds transferred into a rollover IRA continue to grow tax-deferred. This means you won’t owe taxes on your earnings until you begin making withdrawals, typically after reaching retirement age. This tax deferral can allow investments compound more effectively.
The Backdoor Roth IRA Strategy
The traditional contribution (“front door”) for Roth IRAs is currently not available for higher income earners. Married couples filing jointly earning $246,000 or more and single filers earning $165,000 or more in 2025 are still fully excluded from contributing directly to Roth IRAs.
Even though higher earners are ineligible to contribute to a Roth IRA, in 2010, Congress changed the rules and since then anyone can convert a traditional IRA to a Roth IRA. A Backdoor Roth IRA is a strategy for some higher income earners to participate in Roth IRAs. It is a strategy of contributing money into a traditional IRA and then converting that into a Roth IRA, getting all the benefits. While this strategy sounds simple, there are several rules that you must know and follow to make sure you do not incur unintended tax consequences. This is where working with a knowledgeable financial or tax professional can provide guidance and value.
How Does the Backdoor Roth IRA Conversion Work?
The Backdoor Roth conversion can consist of two steps:
- You make a nondeductible contribution to your traditional IRA
- Then, after consulting with your financial or tax professional, you convert this IRA into a ROTH IRA
There is one big caveat: this strategy may work best tax-wise for people who do not already have money in traditional IRAs. That is because in conversions, earnings and previously untaxed contributions in traditional IRAs are taxed—and that tax is figured based on all your traditional IRAs, even ones you are not converting. (Please read the section on the Pro Rata Rule.)
For an investor who does not already hold any traditional IRAs, creating one and then quickly converting it into a Roth IRA may incur little or no tax, because after a short holding period there is likely to be little or no appreciation or interest earned in the account. However, if you already have money in traditional deductible IRAs, you could face a far higher tax bill on the conversion (again, this is covered later in the section on the Pro Rata Rule).
If you choose to attempt a backdoor Roth IRA conversion, please consult a qualified tax planner prior to doing so as the rules for Roth conversions can be complicated.
Am I a Candidate for a Backdoor Roth IRA?
Backdoor Roth IRAS can be appropriate for investors who:
- Only have retirement accounts through their jobs (i.e., 401k’s) and want to increase their retirement savings in tax-advantaged accounts, but whose income is too high to qualify for standard Roth IRA contributions; and
- Have the time and ability to wait for five years or until they are 59 1/2 , whichever is later, to avoid the 10% penalty on early withdrawal.
A Backdoor Roth IRA is probably not recommended if you:
- Do not want to contribute more than the maximum retirement limit through your workplace retirement account.
- Already have money in a traditional IRA and because of the Pro Rata rule may end up in a non-tax advantageous position when converting to a Backdoor Roth IRA.
- Plan or expect to withdraw the funds in the Roth IRA within the first five years of opening it. A Backdoor Roth is considered a conversion and not a contribution. Therefore, the funds may incur a 10% penalty if withdrawn within five years no matter what age.
- Are in a high tax bracket now and expect to be in a lower tax bracket in the future.
- Plan to relocate to a lower or no income tax state.
Example of a Backdoor Roth IRA
Jill, a high-income earner, decides on January 2nd to put $7,000 into a traditional IRA. Jill’s income is too high to be able to deduct these contributions from her taxes. After consulting with a financial professional or tax advisor, she has no other IRAs and then converts the traditional IRAs to Roth IRAs completely tax-free. Her income is too high to make a direct contribution into a Roth IRA, but there is no income limit on conversions. Since Jill could not deduct the contribution anyway, she might as well get the advantage of never paying taxes on that money again available through the Roth IRA.
This is a hypothetical example and is not representative of any specific investment. Your results may vary.
Pro Rata Rule for Roth Conversions
The Pro Rata rule for Roth conversions states that if you have any other deductible IRAs (i.e., a previous 401k that you have rolled over), the conversion of any contributions becomes a taxable event that you will need to pay taxes on upfront.
The Pro Rata rule for Roth conversions determines whether your conversion will be taxable. For taxation purposes, the IRS will look at your entire IRA holdings (even if they are in different accounts), not just the traditional IRA you are converting to a Roth IRA and will determine what your tax bill will be based upon a ratio of IRA assets that have already been taxed to those IRA assets in total.
The IRS determines the tax on this conversion based on the value of all your IRA assets. For example, Sam, a high-income earner, already has $93,000 in an IRA account, all of which has never been taxed. He decides on January 2nd to put $7,000 into a new traditional IRA. The next day he converts the new traditional non-deductible IRA to a Roth IRA. Sam’s income is too high to make a direct contribution into a Roth IRA, but there is no income limit on conversions. He has $93,000 in other IRAs (previously ALL non-taxed), so his total IRA assets are now $100,000. When he converts $7,000 to a Roth IRA, the IRS pro-rates his tax basis on the previous taxation of his total IRA assets, therefore making this conversion 93% taxable ($93,000/100,000 = 93%).
Conclusion
An IRA can be a powerful tool in your retirement planning arsenal, offering investment flexibility, continued tax advantages, and simplified account management. By understanding the mechanics, benefits, and potential pitfalls of rollover IRAs, you can make informed decisions that align with your financial goals.
As you consider your options, consulting with a knowledgeable financial advisor can provide personalized guidance tailored to your unique circumstances. With the right strategies and insights, you can optimize your retirement savings and achieve your long-term financial objectives. Remember, a well-executed financial strategy today sets the foundation for a secure and prosperous retirement tomorrow.
The information provided has been derived from sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be complete analysis of the material discussed, nor does is constitute an offer or a solicitation of an offer to buy any securities, products or services mentioned. This material not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation.
Source: www.irs.gov
