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One of the qualified retirement plans, the Roth IRA, the hero of today’s newsletter, is governed by rules that are just as complicated as numerous.
Roth IRAs are considered extremely valuable tools for retirement because they are designed to offer tax benefits that no other retirement account can. Roth IRAs are able to grow tax free throughout your career and beyond, and unlike many other types of retirement accounts, you don't pay any tax when you take withdrawals from a Roth IRA in retirement.
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A Roth IRA is an IRA that is subject to the same rules that apply to a traditional IRA, except for the following.
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- You cannot deduct contributions to a Roth IRA.
- If you satisfy the requirements, qualified distributions are tax-free.
- You can make contributions to your Roth IRA after you reach age 70 1⁄2.
- You can leave amounts in your Roth IRA as long as you live.
- The account or annuity must be designated as a Roth IRA when it is set up.
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Regardless of your age, you may be able to establish and make nondeductible contributions to a Roth IRA.
To be a Roth IRA, the account or annuity must be designated as a Roth IRA when it is opened. A deemed IRA can be a Roth IRA, but neither a SEP IRA nor a SIMPLE IRA can be designated as a Roth IRA.
The same combined contribution limit applies to all of your Roth and traditional IRAs. But there are also income limits that restrict who can contribute to a Roth IRA.
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The income limits are based on your modified adjusted gross income (MAGI). If your income falls into the Roth IRA phase-out range, your maximum contribution decreases. Generally, you can make the maximum contribution to a Roth IRA if you have taxable compensation and your MAGI for tax year 2019 is less than:
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- $193,000 for married filing jointly or qualifying widow(er);
- $122,000 for single, head of household, or married filing separately and you didn’t live with your spouse at any time during the year;
- $10,000 if married filing separately and you lived with your spouse at any time during the year.
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The contribution limit is phased-out if your MAGI is $203,000 for married filing jointly, and $137,000 for single, head of household, or married filing separately.
The contribution limit also depends on whether contributions are made only to Roth IRAs or to both traditional IRAs and Roth IRAs. The maximum contribution for 2019 is $6,000, or $7,000 if you’re age 50 or older.
If contributions are made only to Roth IRAs, your contribution limit generally is the lesser of:
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- $6,000 ($7,000 if you are age 50 or older), or
- Your taxable compensation.
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If contributions are made to both Roth IRAs and traditional IRAs established for your benefit, your contribution limit for Roth IRAs generally is the same as your limit would be if contributions were made only to Roth IRAs, but then reduced by all contributions for the year to all IRAs other than Roth IRAs. Employer contributions under a SEP or SIMPLE IRA plan don’t affect this limit.
You can make contributions to a Roth IRA for a year at any time during the year or by the due date of your return for that year (not including extensions).
A 6% excise tax applies to any excess contribution to a Roth IRA.
If you withdraw contributions (including any net earnings on the contributions) by the due date of your return for the year in which you made the contribution, the contributions are treated as if you never made them. If you have an extension of time to file your return, you can withdraw the contributions and earnings by the extended due date.
The withdrawal of contributions is tax free, but you must include the earnings on the contributions in income for the year in which you made the contributions.
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You don't include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s). You also don't include distributions from your Roth IRA that you roll over tax free into another Roth IRA. You may have to include part of other distributions in your income.
The Roth IRA allows you to withdraw your money tax-free as long as the account has been open for at least five years and you are 59.5 years old. However, you can withdraw the money at any time and there are other circumstances that allow you to withdraw the money tax free if you don’t meet those criteria. They include a death in the family, disability of the account owner, or education.
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Traditional IRA accounts require that you begin to withdraw money at the age of 70.5. Roth IRAs don’t require you to ever take a withdrawal if you choose not to, although any money in the Roth IRA that is passed on to other generations must be taken as a distribution over their lifetimes.
Also, unlike some retirement accounts, Roth IRAs allow you to keep saving even after your retirement. In fact, you can continue to contribute through your retirement if you work, as long as you don’t exceed the income requirements, and you can even pass this money to other family members after your death.
A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.
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- It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
- The payment or distribution is:
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Made on or after the date you reach age 591/2,
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Made because you are disabled,
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| c. |
Made to a beneficiary or to your estate after your death, or
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| d. |
Even if you are under age 591/2, you don't have to pay the 10% additional tax on up to $10,000 of distributions you receive to buy, build, or rebuild a first home.
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If you receive a distribution that isn't a qualified distribution, you may have to pay the 10% additional tax on early distributions as explained in the following paragraphs.
If you receive a distribution from your Roth IRA that isn't a qualified distribution, part of it may be taxable. There is a set order in which contributions (including conversion contributions and rollover contributions from qualified retirement plans) and earnings are considered to be distributed from your Roth IRA. Order the distributions as follows.
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| 1. |
Regular contributions. |
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| 2. |
Conversion and rollover contributions, on a first-in, first-out basis (generally, total conversions and rollovers from the earliest year first). Take these conversion and rollover contributions into account as follows:
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- Taxable portion (the amount required to be included in gross income because of the conversion or rollover) first, and then the
- Nontaxable portion.
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Earnings on contributions. |
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| 4. |
Disregard rollover contributions from other Roth IRAs for this purpose. |
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IRA conversions and rollovers generally refer to the act of transferring assets held in a traditional IRA, or a similar retirement account, to a Roth IRA.
A rollover is a tax-free distribution to you of cash or other assets from one retirement plan that you contribute to another retirement plan within 60 days you received the payment or distribution. You can withdraw all or part of the assets from a traditional IRA and reinvest them (within 60 days) in a Roth IRA. The amount that you withdraw and timely contribute (convert) to the Roth IRA is called a conversion contribution.
The types of IRAs you can rollover to a Roth IRA are: traditional IRA, rollover IRA, SEP-IRA, Simple IRA, SARSEP IRA, 401K or 403(b) from a former employer, and 457(b). We will give you more information on rollovers and conversions in a separate newsletter.
With any type of retirement account, you will owe taxes now, or you will owe taxes later. Paying taxes on your money now and investing in a Roth IRA means you’ll manage to shield yourself from paying taxes on those funds in the future. Since many people believe income taxes could be considerably higher in the future, this is often seen as a favorable deal.
Because you can withdraw your contributions to a Roth IRA without penalty at any time, the Roth IRA is also used as a long-term savings vehicle for many people.
The downsides of a Roth IRA revolve around the fact that any contributions you make to a Roth IRA are not tax deductible, therefore they do not reduce your gross income, so you won’t be able to receive other tax breaks as a result of showing a lower income.
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Also, if your income exceeds a certain amount you are not eligible to contribute to a Roth IRA. This can cause problems with your retirement accounts if you opened a Roth IRA and then your income grows beyond the contribution eligibility limits.
This is one more reason why you should ask for professional help to figure out which are the most suitable retirement plans for your particular financial situation.
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