A Roth IRA is a means to save money for your retirement that offers certain tax benefits. We are taking a detailed look at this here.
A Roth IRA is an individual retirement account in which money grows tax-free; Roth IRA withdrawals in retirement are also tax-free. Savers at least 59½ years old – and who hold their accounts for at least five years – can take distributions, including earnings, without paying federal taxes.
How does a Roth IRA work?
Like a traditional IRA, a Roth IRA is an account that holds your investments, rather than an investment itself. What your Roth IRA earns and whether you lose money depends on how you invest.
You open a Roth IRA with a financial planner at a brokerage or bank. Then you select what you want to invest in, such as mutual funds, stocks, bonds, exchange-traded funds (ETFs), or bank savings products.
For a long-term goal like retirement, you might consider investing in stocks and bonds because of their higher returns. This is where having an experienced financial planner, like RJG Financial & CPA services, is to your advantage.
How much can you contribute to a Roth?
You can add money to it over time. Also, you can contribute one lump sum or make smaller contributions over the course of the year, as long as your contributions don’t exceed $6,000 ($7,000 if you’re 50 or older) or your taxable compensation, whichever is smaller.
What’s more, you can add money to a Roth by rolling over money from another retirement account. You also can do a partial Roth conversion rather than a total conversion of an account.
Traditional IRA versus Roth IRA
If you want an immediate tax break, consider a traditional IRA. If you prefer the idea of tax-free income in retirement, a Roth IRA is a good idea.
- Roth IRAs are a smart savings tool for young people just starting out, because they’re likely to face higher income tax rates as they move along in their career.
- Someone further along on their career path may also like a Roth IRA, because they provide tax-free income in retirement. That provides what some financial advisors call “tax diversification.”
- Money placed in accounts, such as 401(k)s and traditional IRAs, leads to tax bills in retirement. A Roth IRA can offer a convenient way to manage that tax bill; for example, by pulling at least some income from the Roth to avoid being pushed into a higher tax bracket.
Advantages and benefits of a Roth IRA
Roth IRAs are worth it if you expect your tax rate to be higher in the future. That’s because you contribute money now that you’ll pay income taxes on this year. That is, you don’t get a tax break on your contributions — with a Roth, the tax break comes later.
If your tax rate is lower now, it makes sense to pay taxes now in return for tax-free retirement withdrawals. But even if you’re not sure about your future tax bill, opening a Roth IRA can be a smart move for other reasons.
Advantages and benefits
- Easy withdrawals. You can withdraw the money you contributed any time, without taxes or penalty. (You may be taxed or penalized if you withdraw investment earnings.)
- Multiple contributions. You can contribute to a Roth in addition to a 401(k). In 2019 and 2020, the Roth limit is $6,000 per year ($7,000 if you’re 50 or older), up from $5,500 and $6,500 in 2018.
- Flexible timing. You can choose when you contribute to a Roth IRA, and how much you contribute, up to the annual maximum. For example, you could contribute $6,000 on the first day of the year or split up your contributions over many months.
- Extra time to contribute. You have until the tax deadline to contribute.
- Tax-free distributions. Once you hit 59½ and have held the account for at least five years, you can take distributions, including earnings, from a Roth IRA without paying federal taxes.
- No age limit to open. You can open a Roth IRA at any age, as long as you have earned income (you can’t contribute more than your earned income).
- No RMDs. Roth IRAs aren’t subject to the required minimum distributions (RMDs) required from a traditional IRA or 401(k) starting at age 72 (prior to the passage of the SECURE Act at the end of 2019, the age was 70½).
Am I eligible for a Roth?
Here are the basic qualifications.
- Earned income. To contribute to a Roth or traditional IRA, you must have income from work (the IRS term is “taxable compensation”). The maximum annual contribution in both 2020 and 2019 is $6,000 ($7,000 if you’re age 50 or older) or your income from work, whichever is less.
- Under the income threshold. You won’t be eligible for a Roth if you earn too much. The amount you can contribute to a Roth IRA begins to shrink at certain thresholds for modified adjusted gross income, and keeps shrinking as income rises, until your ability to contribute is eliminated completely.
Note: The income limits apply to your modified adjusted gross income (MAGI), which is your adjusted gross income with some deductions and exclusions added back in. (See IRS Publication 590-A, Worksheet 2-1, for complete instructions on figuring MAGI for Roth IRAs.)
How to open a Roth IRA
Most brokers (in-person or online), banks, financial planners, and robo-advisors offer Roth IRAs.
Banks. Because most banks offer access to savings vehicles (like CDs), rather than investments, they are generally not the best place to open an IRA, which should be geared toward long-term growth.
Robo-advisors. A good first step in the Roth IRA shopping process is deciding whether you want to take a hands-off approach to investing — in which case a robo-advisor and its automated investment process might be appealing — or a more active approach to choosing your investments, which might make a traditional broker more attractive.
Financial planners. A financial planner, like RJG Financial a& CPA Services, can offer more than just the means to open a Roth IRA or make a Roth conversion. They can help you with planning retirement income and minimizing taxes in any number of ways to make your future how you would prefer it to be.
When can you withdraw from a Roth IRA?
Here are three things to remember.
- You can withdraw your contributions whenever you want – without owing any penalties or taxes – no matter how long your account has been open. That’s because the money you put in is money you already paid income tax on.
- When you withdraw money from a Roth IRA, the IRS always assumes your contributions come out first.
- However, the IRS will want a piece of investment returns you earn on the money in your account, in the form of income taxes and possibly an early withdrawal penalty (there are some exceptions to those rules, which make it possible to withdraw even your investment earnings without penalty).
You can withdraw contributions any time, but you can’t withdraw earnings without penalty for five years — unless you have a qualified exception, such as a first-time home purchase.
For the most part, Roth IRA withdrawal rules are more flexible than those for a 401(k) or even a traditional IRA.
Because you already paid taxes on the money you’ve contributed to a Roth IRA, you can withdraw your contributions any time, without penalty.
The key word there is contributions — the money you put into the account. Different rules apply to your investment earnings.
To withdraw investment earnings without owing income taxes and a 10% penalty, you’ll have to follow specific distribution rules, based on your age and how long you’ve owned the account.
If you’re younger than 59½ and you’ve owned a Roth IRA for less than five years
In general, you’ll owe income taxes and a 10% penalty if you withdraw earnings from your account. You can avoid the penalty, but not the income taxes, if you meet one of the following exceptions.
- You’ll owe income tax but no penalty on earnings that you withdraw.
If you’re younger than 59½ and you’ve owned a Roth IRA for five years or more
You can avoid taxes and penalties on earnings you withdraw from your account if you meet one of the following exceptions.
- You can withdraw earnings with no tax or penalty.
Roth IRA Conversions
An interesting thing about Roth IRAs is that there’s a relatively easy way to sidestep the income limits and fund a Roth anyway. High earners can still get their money into a Roth:
- Open a traditional IRA, and then convert that money to a Roth IRA.
- There’s no limit on how much you can convert – but you may face a big tax bill if you have a lot of pre-tax money in your traditional IRA accounts.
When figuring your tax bill on a conversion from a traditional to a Roth IRA, the IRS will look at all of your traditional IRA accounts combined.
- For example, if your traditional IRAs add up to 70% pre-tax money and 30% after-tax money, that ratio determines what percentage of the money you convert to a Roth will be taxable.
- In this example, no matter how much money you convert or which IRA account you pull the money from, 70% of the amount you convert to the Roth will be taxable.
- A word about timing: the IRS applies the pro-rata rule to your total IRA balance at year-end, not at the time of conversion.
Spousal Roth IRAs
While you have to have money from work to contribute to a Roth, there is one exception to that rule:
For a married couple that files their taxes jointly, if one spouse isn’t working for pay, that spouse can contribute to a spousal IRA. That’s as long as that spouse’s contributions – and the working spouse’s contributions, added together – don’t exceed the couple’s taxable compensation for the year.
As long as the working spouse’s taxable compensation is at least $12,000, each spouse can contribute $6,000 to each of their respective accounts. Or, if both spouses are 50 or older and compensation is $14,000 or more, each spouse can contribute $7,000.
The spousal IRA is in the non-working spouse’s name and is just like any traditional or Roth IRA.
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