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Roth IRA

Last Updated on: 30-12-2021
Written by: Rick Pendykoski

What is Roth IRA?

Roth IRA was established in 1997 and named after William Roth, a former Delaware Senator. Although Roth IRAs are similar to traditional IRAs, the biggest difference is in how they are being taxed.

A Roth IRA is a tax-advantaged retirement savings account that is funded with after-tax dollars (contributions are not tax-deductible). The savings in a Roth IRA grow tax-free, and withdrawals are also tax-free.

According to the Roth IRA rules, as long as you’ve been an owner of the account for 5 years and you are 59½ years or older, you can withdraw your money whenever you want without owing any federal taxes.

How much can I contribute to Roth IRA?

Roth IRA contributions are funded with after-tax dollars. However, you need to keep in mind that your eligibility to contribute to a Roth IRA depends on your income level.

  • If you file taxes as a single person, then to contribute to a Roth IRA, your Modified Adjusted Gross Income (MAGI) has to be below $161,000 for the tax year 2024, below $153,000 for the tax year 2023 and below $144,000 for the tax year 2022.
  • If you are married and file taxes jointly, your MAGI must be below $240,000 for the tax year 2024, $228,000 for the tax year 2023 and under $214,000 for the tax year 2022.
  • The maximum total annual contribution for all your IRAs combined is:
    • $7,000 if you’re under 50 years
    • $8,000 if you’re 50 years or older

Roth IRA rules: Who can contribute to a Roth IRA?

Who’s eligible for a Roth IRA? Anyone whose income is taxable can contribute to a Roth IRA. However, you need to meet certain requirements regarding filing status and MAGI. If your income is above a certain amount, you become ineligible to contribute to a Roth IRA.

Here is some more information that you need to know about tax deduction limits

The IRS not only dictates how much to contribute but also defines the type of money you can deposit in your Roth IRA: you can only contribute earned income to a Roth IRA.

  • If you are an employee, the compensation that is eligible for contributing to a Roth IRA is your salary, wage, commission, bonus, and other amounts that is paid to you for the service you perform for your employer.
  • You can also contribute money related to divorce (child support, alimony, or in a settlement).

Funds that are not eligible include:

  • Interest income
  • Rental income or other earnings from property maintenance
  • Stock dividends and capital gains
  • Pension or annuity income

Your contributions to your Roth IRA cannot be more than you earned in that tax year. And as mentioned earlier, your contribution is not tax-deductible; however, you may take a Saver’s tax credit (10%, 20%, or 50% of the deposit), but that depends on your income and your life situation

What are the advantages of Roth IRA?

Listed below are the 8 advantages of the Roth IRA.

  1. Your retirement income is tax-free.
    Unlike traditional IRAs, your contributions towards your Roth IRA are taxed. So, the money in Roth IRA grows free of tax. That’s not all – the distributions you take out from your account in retirement are also free from federal taxes and are likely to be free from the state as well as local taxes.
  2. Your Roth contributions can be withdrawn any time
    As you have already paid the tax, you can withdraw the contributions at any time. However, after 59 ½, both contributions and earnings can be withdrawn tax-free. This can give you a lot of added income when you’re no longer employed full-time. Think of Roth withdrawals as invisible money – not taxed and not a hindrance for Social Security, etc.
  3. It does not make it mandatory for you to take the required minimum distributions
    Traditional IRAs and other employer-sponsored retirement saving plans have required minimum distributions (RMDs). That means, even if you don’t need the distributions, you have to take them because if you don’t, your income may be taxable.
  4. With a Roth IRA, you don’t have to take RMDs
    It allows your money to grow uninterrupted and also enables you to pass on more of your retirement savings to your heirs.
  5. Your heirs can enjoy tax-free money
    In inherited traditional IRAs and Roth IRAs, RMDs must be taken. However, in an inherited Roth IRA, RMDs remain tax-free.
  6. It offers tax flexibility in retirement
    You can make contributions to both a Traditional IRA and/or a Roth IRA. Your total annual limits remain the same. Some financial planners encourage this strategy because it does give a slight tax break in income taxes today and tax-free income at retirement. Also, at retirement, you have a choice of which IRA to draw upon first. For example, at retirement, you can make withdrawals from your traditional IRA until your taxable income hits the top tax bracket. The additional money then can be taken from a Roth IRA.
  7. You can contribute even after you turn 70 ½ years of age
    With a traditional IRA, you have to stop making contributions when you turn 70 1/2 years old. At this age, you have to take taxable distributions. Since Roth IRA has no restriction of RMDs, you can contribute even after you turn 791/2 years of age. That means anyone with earned income can keep on adding to their Roth IRA and enjoy the benefits of accumulated wealth when you are actually not having a source of earned income.
  8. High earners can enjoy the benefits through a ‘back-door’ entry
    The IRS has set some income thresholds for high-income earners that limit the size of the contribution that can be made. If you are a high-income earner, you cannot make a direct contribution to a Roth IRA above that threshold. But, you can still have the benefits of a Roth IRA by making a nondeductible contribution to a traditional IRA and then converting it to a Roth IRA.

What are the disadvantages of Roth IRA?

Listed below are the 4 disadvantages of the Roth IRA.

  1. You pay taxes upfront
    Roth IRAs allow you to make tax-free withdrawals in your retirement. But the contributions you make now are taxable. If you are struggling with your savings, paying tax upfront for your Roth IRA contributions may put you at a disadvantage.
  2. You may have income eligibility restrictions
    Not everyone is eligible to contribute to a Roth IRA. You aren’t eligible if your earned income and your modified adjusted gross income (MAGI) exceeds the annual contribution limits. These annual limits change each year.
  3. You are charged penalties for early withdrawals
    Although you are allowed to withdraw your earnings from your Roth IRA early, you have to pay the penalty unless you are eligible for qualified distributions. To be eligible for qualified distributions, you should have your Roth IRA account open for at least five tax years, and you should have turned 59 1/2 years or are permanently disabled.
  4. You may have a few investment restrictions
    With a Roth IRA, you may have a few investment restrictions. The funds from a Roth IRA cannot be used to invest in collectibles such as metals, gems, antiques, paintings, etc. You also cannot use the funds to buy personal property. For example, you can’t invest in a house that you’ll use as a vacation home. On similar lines, you can invest your Roth IRA funds in businesses, but not your own.

There are pros and cons of Roth IRA contributions. You should seek the advice of a professional investment advisor to see which is best for you, and don’t forget this can change from year to year, depending upon your personal circumstances.

Opening a Roth IRA

You must establish a Roth IRA with an institution that is approved by the IRS to offer IRAs. These usually include brokerage companies, federally-insured credit unions, banks, and savings and loan associations. Most people prefer opening IRAs with brokers.

You can set up a Roth IRA at any time. However, you have to make contributions for a tax year before the tax-filing deadline, which is usually April 15 of the following year. Tax-filing extensions do not apply.

There are two basic documents involved in establishing a Roth IRA:

  • The IRA disclosure statement
  • The IRA adoption agreement and plan document

These documents explain the rules under which the Roth IRA must operate and establish an agreement between you and the IRA custodians/trustee.

Keep in mind that not all financial institutions are created equal. While some IRA providers offer an expansive list of investment options, others have limited options. Their fee structure (which has a significant impact on your investment returns) is also different.

Your investment preferences and your risk tolerance ability play an important role while choosing a Roth IRA provider. If you are an active investor, who trades a lot, you may want a provider with lower trading costs. There are a few providers that charge an inactivity fee if you leave your investments unattended for long.

Some providers offer more exchange-traded funds or diverse stock than others. Your choice of a Roth IRA provider should depend on what type of investment you want in your account.

Also, closely examine the specific account requirements. Some IRA providers have higher minimum account balance requirements than others.

Also, if you are planning on banking with the same institution, check if your Roth IRA comes with additional banking products. If you are opening your Roth IRA at a brokerage or a bank, where you already hold an account, see if there are any IRA fee discounts for existing customers.

How does a Roth IRA work?

Just like any qualified retirement plan accounts, the funds in the Roth IRA grow tax-free. However, Roth imposes fewer restrictions than other accounts.

  • You can continue making contributions at any age as long as you have earned income.
  • You can maintain the Roth IRA indefinitely as you are not expected to take a required minimum distribution (RMD) during your lifetime, as with 401(k)s and traditional IRAs.

You can fund your Roth IRA from a number of sources:

  • Regular contributions
  • Transfers
  • Spousal IRA contributions
  • Conversions
  • Rollover contributions

However, all regular Roth IRA contributions have to be made in cash or checks; you cannot use securities or assets. Once the funds are in your Roth IRA, you can use it to invest in a number of investment vehicles, including stocks, mutual funds, ETFs, bonds, CDs, and money market funds.

The IRS restricts the amount you can deposit in your IRAs. The contribution limits for Roth IRA are the same as for traditional IRAs.

Roth IRA withdrawal rules

A. Withdrawals: Qualified Distributions

You can withdraw your contributions from your Roth IRA at any time. And these withdrawals do not attract penalties nor taxes. If you withdraw an amount that’s equal to the amount you have put in, then the distribution is not considered as taxable income. Hence, it is not subjected to penalty, regardless of how long you’ve had the account or your age. The IRS terms this withdrawal as a qualified distribution.

But there is a catch when it comes to withdrawing any earnings that the account has generated. For a qualified account earning distribution, it must occur only after you’ve owned the Roth IRA for at least 5 years. And the distribution has to meet at least one of the following conditions:

  • You (the Roth IRA holder) has to be at least age 59½ when the distribution occurs.
  • The distributed assets have to be used for purchase – to build or rebuild—the first home for you or a qualified family member (your spouse, child, grandchild, parents, or other ancestors). The limit for this is $10,000 per lifetime.
  • The distribution is taken after you become disabled.
  • The assets are distributed to your beneficiary after your death.

The 5-Year Rule

Withdrawal of your account earnings are subjected to taxes and/or a 10% penalty, depending on your age and whether you meet the 5-year Rule. So, two situations can occur:

If you are under 59½: Your account earnings are subject to penalties and taxes.
But you can avoid taxes and penalties if you:

  • use the money for first-time purchase of a home (lifetime limit of $10,000),
  • have a permanent disability,
  • you pass away (your beneficiary takes the distribution).
    If you are age 59½ and older: No taxes or penalties applicable.

If you are under 59½: Your account earnings are subject to taxes and penalties. You can avoid penalties, but you would have to pay the taxes if you use the money for:

  • first-time home purchase (a $10,000-lifetime limit applies),
  • qualified education expenses,
  • unreimbursed medical expenses,
  • if you have a permanent disability,
  • if you pass away (and your beneficiary takes the distribution).

If you are 59½ and older: The account earnings are subject to taxes but not penalties.

B. Withdrawals: Non-Qualified Distributions

If you withdraw your account earnings without meeting any of the requirements mentioned above, your withdrawal is considered as a non-qualified distribution, and it attracts a 10% penalty and/or income tax. However, there are exceptions if the earnings are used to pay for the following:

  • Medical insurance, if you have lost your job.
  • Unreimbursed medical expenses for the amounts that exceed 10% of your adjusted gross income (AGI) for the year of the distribution.
  • Childbirth or adoption expenses of up to $5,000, if made within one year of the event.
  • Qualified higher-education expenses of your or your dependents. The qualified education expenses include tuition, books, fees, supplies, and equipment needed for the student to enroll and attend an eligible educational institution. This must be used in the same year the withdrawal was made.

There is another loophole in the withdrawal of earnings: If you withdraw only the amount of your contribution made and its earnings within the current tax year, the withdrawal is treated as it was never made. For example, if your contribution in the current year is $5,000 and if that fund has generated earnings of $500, you can withdraw the full $5,500 tax-free and penalty-free if you do it before your tax filing due date.

The spousal Roth IRA

A couple can boost their contribution is through spousal Roth IRA. You may fund a Roth IRA on behalf of your spouse, who no income or earns less. Spousal Roth IRA contributions have the same rules and limits as that of a regular Roth IRA contribution. However, the spousal Roth IRA has to be held separately from your Roth IRA; Roth IRAs cannot be held jointly.

You must meet the following eligibility criteria for you to make a spousal Roth IRA contribution:

  • You must be married and should file a joint tax return
  • If you are making the spousal Roth IRA contribution, you must have eligible compensation.
  • The total Roth IRA contribution for you and your spouse should not exceed the taxable compensation reported on your joint tax return.
  • Contributions to one Roth IRA cannot exceed the maximum Roth IRA contribution limits for one IRA

What are the best investments suited to Roth IRAs?

The best investments suited to Roth IRAs are the ones that:

  • Offers significant growth or substantial capital appreciation
  • Generates high taxable income in dividends or interest
  • Create short-term capital gains through frequent or high turnover

Through these investments, you can truly take advantage of the way the IRS taxes income. This means you would be able to save more for your retirement.

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