A Roth IRA is an investment vehicle that allows you to put away money for your retirement. By opting for this type of individual retirement account, you are making contributions using after tax dollars, which means that you can enjoy tax-free withdrawals at a later time.
Although a Roth provides the ability to avoid being double taxed on your contributions over its lifetime, there are other stipulations that must be met in order to successfully claim your funds and avoid IRS penalties when the time comes. Unlike a traditional IRA, you will also enjoy account growth year after year without paying any taxes on the interest .
How a Roth IRA Works
A Roth IRA works by making contributions with money that has already been taxed as a part of your paycheck. These are known in the financial arena as after tax dollars. As you continue to add funds to your investment, the money grows via compound interest, which may be several percentage points higher than what you would earn via a typical checking or savings account. Withdrawals of any money that you invest into your account, regardless of the amount of interest that it accrues, is done on a tax free basis.
When it comes to opening a Roth IRA there are also certain rules and requirements that you must abide by to keep your contributions eligible and not fall outside of the income guidelines each year, which can also change based on your filing status. Falling outside of the necessary parameters cause penalties or lower the tax benefits available for retirement savers.
Roth IRA Contribution Rules
Contribution rules for depositing funds into a Roth individual retirement account are based on the type of income that is involved. These were set forth by the IRS to reward those who plan ahead for the golden years, while making things easier for people across varying income levels.
A person who is seeking to fund their account can do so via an eligible employer through making payroll deductions into a company sponsored retirement plan. They can also use any commissions or bonuses received for work in the regular course of employment.
However, self-employed individuals may make their contributions via any net business earnings, or money earned from a pass-through entity such as an LLC or Sole Proprietorship, after compensating for required business tax obligations.
The following types of income are not allowed to be used as contributions for an IRA account:
- Interest income – Money paid as a result of an investment or bank account
- Pension funds – Employer sponsored funds that are divided among vested employees
- Stock and investments – Purchased shares or stock in a company
- Partnership based passive income – Income resulting from partnerships where your services aren’t rendered
An additional regulation when it comes to individual retirement accounts is that your contributions cannot exceed the amount of income that you earned during a particular tax year.
Eligibility and Qualifiers
Requirements to open and remain eligible for an individual requirement account heavily take into consideration your gross income, or money earned before taxes each year as well as your marital status.
The following is a table of income and filing status guidelines which determine exactly how much you are able to contribute each year:
|Filing Status||Modified Adjusted Gross Income 2021||Modified Adjusted Gross Income 2022||Contribution Limit|
Single, head of household, or married filing separately (and you didn't live with your spouse at any time during the year)
|Less than $125,000||Less than $129,000||Up to $6,000 to $7,000 per, depending on age|
|Between $125,000 and $140,000||$129,000 to $143,999||A reduced amount available in IRS Guide|
|$140,000 or more||$144,000 or more||Cannot contribute|
Married filing separately (if you lived with your spouse at any time during the year)
|Less than $10,000||Less than $10,000||A reduced amount available in IRS Guide|
|$10,000 or more||$10,000 or more||Cannot contribute|
Married filing jointly or qualifying widow(er)
|Less than $198,000||Less than $204,000||Up to $6,000 to $7,000 per, depending on age|
|Between $198,000 and $208,000||$204,000 to $213,999||A reduced amount available in IRS Guide|
|$208,000 or more||$214,000 or more||Cannot contribute|
Aside from income requirements, there are other ways in which you are eligible to contribute to or receive funds inside of a Roth IRA.
- Spousal IRA – This type of retirement account allows you to make contributions for the benefit of your spouse, if they are not working or earn a smaller amount of income compared to yours. The account as well as contributions are considered separate from the account of the IRA belonging to the marital partner who is adding money to it. Although, to stay eligible for this retirement benefit, both partners must stay within income guidelines, not exceed a contribution limit, file a joint return, and have qualified taxable earnings.
- Roth Conversion IRA – When a person opens up a self-employer or SEP IRA, they are then eligible to do a Roth conversion, which effectively creates a Roth IRA with those funds. One key difference with this scenario is that on a conversion, you will have to pay taxes on the funds that go into the Roth based on the amount as it’s included as ordinary income for that tax year.
Advantages of a Roth IRA
A Roth IRA does come with many advantages as opposed to other types of retirement vehicles. A common one is that it allows you to receive distributions as long as you are eligible without having to pay additional taxes. You can also pass the funds under a Roth IRA to a beneficiary as a tax-free asset upon your death. This allows them to receive distributions over a determined length of time.
Another advantage is that those who expect their retirement income to increase over the years, which allows for a lower tax amount when the ability to work subsides, which acts as a safeguard to the overall nest egg.
Benefits of a Roth IRA
The benefits of opening a Roth IRA can be numerous as they can provide an easy way for younger individuals who haven’t had as much experience with savings over their lifetime. It also encourages older investors to maximize their contributions as they move into roles with higher salaries, since they may pay higher tax rate during working years as opposed to retirement.
Additional benefits of having a Roth include the following:
- Hassle free withdrawals – Roth IRA withdrawals don’t have taxes attached to them
- Flexible investment schedule – Contributions can be made anytime throughout the year as long as they don’t exceed the allowable amount
- Lengthy Deadlines – The IRS allows contributions to be made until April for the previous year
- No RMD – Roth IRAs don’t come with minimum distributions required of traditional accounts once you reach a certain age
- No Age Restrictions – Anyone with earned income can open this type of account
Types of IRA Withdrawals
There are two main categories of withdrawals when it comes to pulling funds from your Roth individual retirement account. These are known as qualified or meeting certain criteria, and non-qualified distributions, which come with a penalty attached.
A qualified withdrawal or distribution is made when you have reached the general retirement age, or that of the company that you are retiring from. In addition to the age requirement, you must also fall under a few very specific rules in order to avoid early withdrawal penalties or fees.
- Use the funds to purchase or rebuild the home of yourself or a qualifying relative
- Be at least 59.5 years of age at the time of the distribution
- Be considered physically or mentally disabled
- No less than 5 years have passed since the account was opened
- Take a distribution as a result of being a beneficiary
Non-qualifying distributions are those that fall outside of the preset rules. However, there are very few instances in which the IRS will grant a penalty waiver if the following circumstances cause an early withdrawal that is otherwise not allowed.
Under the current rules, a person can request a waiver if they are using the funds or medical expenses exceeding 7.5% of their AGI, use the money to cover birth or adoption costs within the initial year, cover medical insurance premiums, or higher education expenses.
It is important to note that even with exceptions to the rule, any funds that are in excess of the allowable amounts or not attached to the heirs or relatives of the person taking a distribution,will not avoid the penalty assessment.
How to Open a Roth IRA
Opening a Roth IRA can be done via an employer sponsored retirement plan as a part of the benefits package. However, you can also open an account with any major brokerage, or some financial institutions that carry these as an option. After the initial screening criteria, you will be allowed to begin using your money to make regular contributions each year.
Roth IRA vs Traditional IRA
Roth IRAs are similar to the traditional IRA in that they both allow you to appreciate tax savings on your investments. Depending on what type of account you prefer, you will either pay taxes on your contributions upfront or after you withdraw them in retirement.
For individuals who earn more in their earlier years, having a Roth could redistribute or offset some of the income taxes paid according to salary by retaining all of the money accumulated inside of the account during later years.
On the other hand, those who have a lower salary, may appreciate the ability to receive a tax break on the funds that they are putting towards retirement during the contribution years, while deferring the taxes until retirement.
Either method will allow an individual to save for their non-working years while accumulating compound interest over a series of decades.
The Roth IRA is a tool that provides you a tax-free route to retirement at an increased interest rate. So long as the income parameters and other requirements are met, it can be a great way to prepare to enjoy the benefits of getting older. Before you decide if a Roth is the right vehicle for you, speak with a financial advisor, or friendly accountant in order to review all of your options.