Financially preparing for retirement can sometimes feel like navigating a maze. With numerous retirement plan options from which to choose, each with its own eligibility requirements and tax implications, choosing a retirement investment vehicle is not a one-size-fits-all decision. Established in 1997, the Roth individual retirement arrangement (IRA) is the perfect fit for many taxpayers who want to enjoy tax-free withdrawals at retirement age.
What Is a Roth IRA?
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Roth IRA vs. Traditional IRA
Traditional IRAs offer a tax break when you contribute to this type of retirement plan, but Roth IRAs offer a tax break when you withdraw your money. If you have a traditional IRA, you’ll have to pay income tax when you withdraw your funds because the contributions you made to this plan were pre-tax dollars. Roth IRAs are the opposite – you contribute money with post-tax dollars, but you typically won’t pay income tax when you withdraw your funds. Your heirs must pay income tax when they receive any remaining funds in your traditional IRA, but they will receive your Roth IRA distributions tax-free. Once you’ve reached the age of 70 1/2, you’re required to make annual withdrawals from a traditional IRA, or pay a penalty. But with a Roth IRA, you’re not required to make annual withdrawals; in fact, you’re not required to make any withdrawals at all.
Roth IRA vs. 401K
When you deposit funds into your Roth IRA account, you’re depositing income that’s already been taxed, but when you deposit funds into your 401(k) account, you’re depositing funds that have not yet been taxed. This means that when you withdraw money from your Roth IRA, you won’t have to pay tax on it (because you already paid tax on this income), but when you withdraw funds from your 401(k) account, you’ll owe income tax (because it was tax-deferred income).
Another notable difference between a Roth IRA and a 401(k) retirement plan is the involvement of your employer. With a Roth IRA, your employer is cut out of the equation. But 401(k) plans typically have an “employer matching” feature, which means that your employer kicks in a certain amount of money to your 401(k) fund, based on the amount of your own contributions. These matching contributions vary, depending on the type of 401(k) plan you have.
Roth IRA Income Guidelines
Contributions to a Roth IRA are income-driven, but you'll have to have certain types of income to contribute to this type of retirement plan. Most income types must be “earned income” (instead of “unearned income”), although the IRS does allow alimony and separate maintenance income. Examples of income that qualifies for a Roth IRA include wages, salaries, commissions and self-employment income. Examples of income that doesn’t qualify for a Roth IRA include rental income, pensions, interest income and dividends.
Roth IRA Income Limits
To determine if your income is eligible for a Roth IRA, use Worksheet 2-1 (Contributions to Individual Retirement Arrangements [IRAs]) in IRS Publication 590-A. You can download this publication by visiting IRS.gov/forms. When the page loads, enter “Publication 590-A” in the “Forms, Instructions and Publications” search box, and follow the prompts and clickable links to find this worksheet.
Typically, if your filing status is married filing jointly or qualifying widow(er), you’ll be able to contribute to a Roth IRA if your modified adjusted gross income is less than $196,000. If your filing status is single, head of household or married filing separately (and you lived apart from your spouse for the entire year), your modified adjusted gross income must be less than $133,000. And if your filing status is married filing separately, but you did live with your spouse for any part of the year, your modified adjusted gross income must be less than $10,000. Publication 590-A lists exceptions to these income guidelines.
Roth IRA Contribution Limits
The IRS puts a cap on the total amount of contributions that taxpayers can make to their traditional IRAs and Roth IRAs. This maximum contribution limit may change from year to year, depending on new tax laws. For tax years 2015 through 2018, the IRS allows taxpayers a total maximum contribution of $5,500 to their Roth and traditional IRAs, or the amount of their taxable compensation (if their compensation was less than $5,500). Taxpayers 50 and older can contribute up to $6,500. If you contribute more than the maximum amount, you'll owe a 6 percent excise tax on the overage.
In some cases, if your modified adjusted gross income is higher than a certain amount, your maximum contribution limit may be reduced. Refer to Table 2-1 (Effect of Modified AGI on Roth IRA Contributions) in IRS Publication 590-A to see if this reduction applies to you. If it does, fill out Worksheet 2-2 (Determining Your Reduced Roth IRA Contribution Limit) in the same publication to determine your contribution amount.
Roth IRA Contribution Deadline
If you haven’t made a contribution to your Roth IRA by the end of the year, you still have time to do this. Although you can make contributions at any time during the year, the deadline for contributing to your Roth IRA is by the tax filing deadline, not the end of the calendar year. For most people, this means April 15 (or the next business day if April 15 falls on a weekend or federal holiday).
Roth IRA Withdrawal Rules
You’re not penalized for withdrawing any amount of your contributions to a Roth IRA plan, with a distinction made between “contributions” and “earnings.” The difference is that “contributions” represent the amount you deposit into your Roth IRA, and “earnings” represent the amount of interest you earn on your deposits. If you withdraw any of your earnings before you reach the age of 59 1/2, you’ll have to pay income tax plus a 10 percent penalty on the amount of your withdrawal. But you won’t owe taxes or penalties on your earnings until you’ve withdrawn all of your contributions. After the age of 59 1/2 (if you've had your Roth IRA for at least five years), you can make tax-free (and penalty-free) withdrawals of your earnings as well as your contributions.
Roth IRA Withdrawal Rule Exceptions
The IRS allows some tax-free and penalty-free exceptions to withdrawing your Roth IRA earnings. If you’ve had your Roth IRA for at least five years, you can withdraw your earnings for these notable reasons without paying taxes or penalties:
- You're at least 59 1/2 years old. You can withdraw your first penalty-free earnings on or after the date you reach this age.
- You become disabled. IRS Publication 590-B (Distributions from Individual Retirement Arrangements [IRAs]) defines “disabled” as a condition that “can be expected to result in death or to be of long, continued, and indefinite duration.” A physician must provide proof that your physical or mental condition, which meets this definition, renders you unable to perform any “substantial gainful activity.”
- Your beneficiary/beneficiaries inherit your Roth IRA. After your death, your beneficiary/beneficiaries or estate may withdraw all your Roth IRA funds without paying a penalty.
- You’re buying, building or rebuilding your first house. In addition to withdrawing your Roth IRA contributions, you’ll also be able to withdraw up to $10,000 of your Roth IRA earnings. And if both you and your spouse have Roth IRAs, this amount is doubled – up to $20,000 ($10,000 for each spouse). Even if you haven’t had your Roth IRA for five years, you’re exempt from paying a penalty (although you’ll still owe income tax on your earnings withdrawal amount). Another perk is that the house doesn’t have to be yours; it can be for any qualified family member, including your parent, child or grandchild.
Refer to IRS Publication 590-B to review other penalty-free exceptions for early distributions.
Opening a Roth IRA
Your tax accountant or tax lawyer should be able to steer you in the right direction for establishing a Roth IRA. But if you don't hire either of these professionals, you can do the homework and legwork yourself to find the plan that's best for you. Banks (and other financial institutions), brokers and mutual fund investors, which are IRS-approved to open Roth IRAs, can also help you get started. If you’re comfortable with a digital interface, you can even find online brokerages with user-friendly platforms that walk you through opening and maintaining your Roth IRA account. You’ll choose among different investing options, including stocks, bonds, mutual funds, certificates of deposit and money market accounts.
Opening Roth IRA for Spouse
Roth IRAs cannot be jointly held; if you’re married, you have to establish your own Roth IRA that’s separate from your spouse’s account. But if you’re married to someone who has little or no income, you can set up and fund an account for your spouse. The IRS sets these eligibility requirements for a spousal IRA:
- You must be married, and you must file a joint tax return with your spouse.
- You must have eligible compensation, just as you’d have for your own account.
- The total amount of the contributions for both spouse’s accounts cannot be more than the taxable income reported on their joint tax return.
- Each spouse’s Roth IRA must stay within the contribution limits for one account, even though the combined accounts offer double savings.
Backdoor Roth IRA
Although Roth IRAs are not tailored for high-income taxpayers because of the maximum income allowed to qualify for these plans, the “backdoor” method is an IRS-allowed way to overcome this restriction. You may be able to transfer funds that you have in other IRAs, such as traditional IRAs, Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs, to your Roth IRA, no matter the amount of your modified adjusted gross income. Another option may be to rollover the amount you have in a qualified retirement plan to your Roth IRA. This maneuver may be best undertaken with the advice of a professional tax adviser or accountant. Chapter 2 in IRS Publication 590-A offers more details and limitations on Roth IRA conversions and rollovers.
- Roth IRA rules | Vanguard
- IRS: Roth IRAs
- Kiplinger: Why You Need a Roth IRA
- 403 Forbidden
- IRS: Publication 590-A
- IRS: Retirement Topics - IRA Contribution Limits
- Open a Traditional IRA | Alliant Credit Union
- Charles Schwab: The Backdoor Roth - Is it Right for You?
- IRS: Topic Number 309 - Roth IRA Contributions
- IRS: Publication 590-B
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Victoria Lee Blackstone was formerly with Freddie Mac’s mortgage acquisition department, where she funded multi-million-dollar loan pools for primary lending institutions, worked on a mortgage fraud task force and wrote the convertible ARM section of the company’s policies and procedures manual. Currently, Blackstone is a professional writer with expertise in the fields of mortgage, finance, budgeting and tax. She is the author of more than 2,000 published works for newspapers, magazines, online publications and individual clients.