What is a Roth IRA?
A Roth IRA is a type of individual retirement savings account — similar to traditional IRAs and 401(k) plans. Like other retirement savings plans, investment income earned is not taxed, and there are penalties for taking money out early from the plan. What is distinctive about Roth IRA accounts is that withdrawals from the plan can potentially be entirely tax-free, as long as certain conditions are met. Because of this potential to accumulate tax-free investment income, Roth IRAs present a unique tax planning opportunity for savers and investors.
Distributions from a Roth IRA are completely tax-free, as long as you meet certain conditions. You may be able to contribute to a Roth IRA even if you are covered by a retirement plan at work. Be aware that Roth IRAs do have income restrictions regarding who can contribute a Roth.
Tax Benefits and Disadvantages of a Roth IRA
Unlike traditional types of retirement plans, there is no tax deduction for contributing funds to a Roth IRA plan. Instead, withdrawals (also called distributions) from a Roth IRA account are tax-free as long as certain conditions are met. Essentially, a Roth IRA is a post-tax savings vehicle (in contrast to the pre-tax or tax-deductible retirement plans).
The main disadvantage of a Roth IRA is that the savings inside the Roth are tied up until you reach age 59.5 years old.
There are some exceptions allowing you to withdraw funds earlier. Absent any exceptions, an early distribution from a Roth IRA will be subject to a 10% federal tax penalty and any earnings withdrawn would be taxable.
Summary of tax benefits
- Investment income earned inside a Roth IRA is not reported on your annual tax return.
- Withdrawals from a Roth IRA can be entirely free from federal taxes.
- Roth IRAs do not have mandatory minimum distributions.
- Roth IRAs can be bequeathed to heirs and thus can escape both income taxes and estate taxes.
Summary of disadvantages
- Early withdrawals from a Roth IRA can be subject to taxes and penalties.
- There are income restrictions for being eligible to fund a Roth IRA.
- Losses in a Roth IRA are tax-deductible only if you cash out all your Roth IRAs, which might not always prove advantageous.
Criteria for Tax-Free Roth IRA Distributions
Funds withdrawn from a Roth IRA will be completely tax-free as long as the following criteria are met:
- The distribution is made after five years from the date when you first began contributing to a Roth IRA; and
- The distribution is made after you reach age 59.5 years old, or because you are disabled, or paid to a beneficiary after your death, or to purchase a home for the first time.
Together these criteria make a withdrawal a “qualifying distribution” from a Roth IRA and the withdrawal qualifies for tax-free treatment.
Tax Treatment for Non-Qualifying Distributions from a Roth IRA
Withdrawals from a Roth IRA account that don’t meet the criteria to be a qualifying distribution are partially taxable. Your original contribution to the Roth IRA is returned tax-free, but any earnings and growth are fully taxable. The taxable portion of the Roth withdrawal is also subject to the 10% early distribution penalty.
How Much can be Contributed to a Roth IRA?
The maximum amount that can be contributed to a Roth IRA is $5,500 for 2016.
People age 50 or older can contribute an additional $1,000 to their Roth IRA as a catch-up contribution.
This limit applies to both Traditional and Roth IRAs collectively. You can contribute to both a Traditional and a Roth IRA if you want, but the combined total cannot exceed the maximum for a given year. If you do exceed the maximum, you will need to correct the problem by taking a corrective distribution before the due date of your return.
Contribution Limits to a Roth IRA based on Income
The contribution limit represents the maximum that can be contributed per year. A person’s actual Roth IRA contribution limit can be further reduced or eliminated depending on their income level for the year.
One limit is called the earned income limit. You can contribute up to the lower of the contribution limit or your earned income for the year, whichever is less. For IRA purposes only, earned income consists of wages (reported on a W-2), self-employment income from a business
The second limit is based on your modified adjusted gross income. To determine your eligibility, you need to know your modified AGI (adjusted gross income) and filing status.
The income limits typically rise a bit every year because of inflation. For 2016, the Roth IRA contribution limit is phased out based on the following income levels:
- For single or head of household filers, the phase-out range is $117,000 to $132,000. If your modified AGI is more than $132,000, you cannot contribute to a Roth IRA.
- For those who are married, filing jointly, the phase-out range is $184,000 to $194,000. If your combined, modified AGI is more than $194,000, you cannot contribute to a Roth IRA in 2014.
- Finally, if your filing status is married filing separately (you lived with your spouse at any time during the year), the phase-out range is $0 to $10,000. If you make more than $10,000 and file married filing separately, you cannot contribute to a Roth IRA in 2016.
Converting Funds from Other Retirement Accounts to a Roth IRA
Tax-deductible funds from a traditional IRA or 401(k) or similar pre-tax savings plan can be converted to a Roth IRA. Converting to a Roth means undoing the tax-deferral by paying tax on the accumulated earnings and on any savings contributions for which the person took a deduction. This converts the pre-tax funds into post-tax money. Unlike the Roth IRA contribution limits, there are no income restrictions for converting to a Roth IRA.
Using the Conversion Rules to Fund a Roth IRA
This creates a tax planning opportunity for higher-income people who are not eligible to fully fund a Roth IRA directly. Higher income taxpayers could fund a non-deductible, traditional IRA and then later convert that traditional IRA to a Roth.