A Roth IRA is an individual retirement account (IRA). This allows you to have qualified withdrawals on a tax-free basis as long as certain conditions have been met. A Roth IRA is very similar to a Traditional IRA with the biggest difference being how they are taxed.
Your Roth IRA will be funded with after-tax dollars and the contributions are not tax-deductible. This means you will be putting your money into an IRA after you’ve paid taxes on the cash.The best part is that when you start withdrawing money it is tax-free, since you’ve already paid taxes.
Roth IRA Basics
A Roth IRA is less restrictive than other similar types of retirement accounts. You can contribute at any age as long as it is earned income and already taxed. You can also maintain a Roth IRA indefinitely and there are no required minimum distributions, unlike with 401(k)s or Traditional IRAs.
You can fund your Roth IRA from a few sources:
- Regular Contributions
- Spousal IRA Contributions
- Rollover Contributions
All regular Roth IRA contributions must be made with cash and cannot be in the form of securities or assets. However, once you’ve put money into your Roth IRA account there are a variety of investment options like investing in stocks, investing in mutual funds, bonds, ETFs or even CDs. The IRS does limit how much you can deposit into your IRA.
The maximum annual contribution you can make to a Roth IRA is $6,000. If you’re 50 years old or higher you can make up to $7,000 in qualified contributions.
How to Open a Roth IRA Account
A Roth IRA can only be opened with an institution that has received IRS approval to offer IRAs. These institutions include banks, brokerage companies, federally insured credit unions and savings and loan associations. For the most part, individuals open up a Roth IRA with a brokerage company.
You can establish a Roth IRA at any time, however, your contributions for a tax year must be made by the IRA owner’s tax-filing deadline. It’s generally April 15th each year. Tax-filing extensions do not apply.
In order to open an IRA you need to supply the IRA owner with when you establish your IRA:
- IRA Disclosure Statement
- IRA Adoption Agreement and Plan Document
These two documents provide an explanation of the rules and regulations under which a Roth IRA must operate and creates an agreement between you and the IRA custodian. You should shop around as not all Roth IRA providers have the same investment options and some can be pretty restrictive. You will find that each institution has their own fee structure so you’ll want to be aware of what fees they are charging and when. These fees can have a significant impact on how much retirement savings you have left when you go to retire or withdraw.
Are Roth IRAs Insured?
If your account is located at a bank then your IRA falls under a difference insurance category than a typical savings account. The FDIC still insures up to $250,000 but all of your account balances are combined instead of viewed individually. For example, if you had two Roth IRA accounts with $200,000 in each then you would get the max $250,000 and not $200,000 for each account as the government would view your total balance as $400,000.
Roth IRA Contributions
The IRS will dictate how much money you can deposit but also the type of money you deposit. You can only deposit earned income to a Roth IRA. The earned income must be taxable and already have taxes taken out of it.
Money related to divorce like alimony, child support or a settlement is all eligible to be used for your Roth IRA.
The money you cannot use to fund an IRA are:
- Rental Income
- Interest Income
- Pension or Annuity Income
- Stock Dividends and Capital Gains
You also can never contribute more to your Roth IRA than you’ve made in the year. You receive no tax-deductions for contribution.
Who is Eligible for a Roth IRA?
If you have taxable income, you’re eligible. You’ll still have to meet other requirements like a filing status and adjusted gross income. If you have an annual income above a certain amount you can become ineligible to contribute.
Income Qualifications for a Roth IRA
|Category||Income Range for 2019||Income Range for 2020|
|Married, Filing a Joint Return||Full: Less than $193,000|
Partial: $193,000 to $203,000
|Full: Less than $196,000
Partial: $196,000 to $206,000
|Married, Filing a Separate Return||Full: $0|
|Single, Head of Household||Full: Less than $122,000|
Partial: $122,000 to $137,000
|Full: Less than $124,000
Partial: $124,000 to $139,000
If you make more than the above income qualifications then you may not be eligible for a Roth IRA, however, in many cases you may just be limited in your annual contribution. If you make less than the income ranges above then you’re allowed to contribute up to 100% of the annual contribution of $6,000 or $7,000 depending on your age
Roth IRA Withdrawals: Qualified Distributions
You may withdraw from your Roth IRA at any time both tax and penalty free. If you take out only the amount equal to what you’ve put into the account then you won’t have to pay any taxes on that money or incur any penalties. You can even withdraw your contribution amount before retirement. The IRS considers this a qualified distribution. For example, if you were to put in $20,000 over a period of time and you went to withdraw that $20,000 you will not be penalized.
A large caveat to a Roth IRA is that any earnings the account has made cannot be distributed until after 5 years from opening. This means you cannot set up a Roth IRA account and fund it for two years just to close it and take your money. You will be able to pull out your contribution but any earnings will be stuck until the account is 5 years old.
In order to distribute your earnings in your Roth IRA account, one of the following conditions must be met:
- You are at least 59.5 years old.
- The distribution is used to purchase your first home, or a relatives first home, with a max of $10,000. This is often used as a down payment for a house for some individuals.
- You have become disabled.
- You have passed away and the funds will be dispersed to the beneficiary.
If you withdraw before the 5-year mark is up you will have to pay taxes and a 10% penalty. If you’ve met any of the conditions above then the 5-year mark is typically waived and you incur no taxes or penalty.
Roth IRA Withdrawals: Non-Qualified Distributions
A non-qualified distribution is one that doesn’t meet the conditions of a qualified distribution. If you do not meet the age requirement, you haven’t become disabled or you haven’t passed away then any withdrawal from your Roth IRA is considered a non-qualified distribution.
Each non-qualified distribution is subject to taxes and a 10% withdrawal fee.
There are some instances where the account holder, and government, may waive non-qualified distribution fees and these are:
- If you’re paying unreimbursed medical expenses that exceed 10% of your yearly income.
- To pay for medical insurance if you’ve faced hardship (lost a job).
- To pay for higher-education (tuition, fees, books, etc.).
- If you are having a child or adopting, you’re eligible to get up to $5,000 if the Roth IRA was made within one year of the event.
Roth IRA vs Traditional IRA
There are a few key differences between a Roth IRA and a Traditional IRA. The differences are around tax breaks, income limits, distribution rules, and pre-retirement withdrawals.
Both of these IRAs provide great tax breaks but it ends up being a matter of timing for when you need the retirement money.
A Traditional IRA is tax-deductible for your state and federal taxes for the year you make the contribution. Since you can claim them as a tax dedication, a contribution to a traditional IRA lowers your total income for the year. The lower income can be fruitful if you’re trying to apply for tax advantage retirement accounts or to qualify for other tax-incentive based opportunities. Since it is tax-deductible for the year you’ve made contributions, you will have to pay an income tax when you retire.
A Roth IRA does not give you a tax deduction for your state or federal taxes so they are not lowering your total income for the year. As a result, any withdrawal in retirement is tax-free. If you’re able to, a Roth IRA is the best option to go if you don’t want to pay a lump sum of taxes in retirement.
If you’re under 70.5 years old and have a valid earned income then you’re able to contribute to an IRA account, whether it’s a Traditional IRA or a Roth IRA. Both IRAs do not have an age restriction but they do have income-eligibility restrictions.
There is no income limit for a Traditional IRA account.
There are income limits for a Roth IRA account. For the current year, 2020, it goes based on your tax filing status. If you’re a single filer must have an adjusted gross income of less than $139,000. If you’re married then your modified income should be less than $206,000.
As you approach retirement, the difference in distribution rules between the two types of accounts gets pretty black and white.
A Traditional IRA will force you to start taking required minimum distributions which are mandatory, taxable withdrawals of a percentage of your funds at age 70.5. It doesn’t matter if you need the money or not, they force you to take it out.
A Roth IRA does not have any minimum required distributions and you’re not required to withdraw it at any age or even in your lifetime. If you’ve set up a Roth IRA you can essentially leave it there until after you pass away and the beneficiary will get all of the savings. Many use them as a “wealth-transfer vehicle”, meaning they use it as an inheritance and keeping it in the Roth IRA is much safer than a standard bank account. The only downside to this is that the beneficiary is required to take distributions or roll all of the amount into their own Roth IRA, if they qualify.
A Roth IRA allows you to take qualified distributions before 59.5 years old. As long as they meet the conditions outlined above or you’re only taking out your contribution and not your earnings.
A Traditional IRA taxes you on any withdrawal before 59.5 years old. You will also incur a 10% penalty for early withdrawal.
There are a few considerations for each that you can take into account that may help you waive the 10% fee or taxes entirely. You can use the money as a downpayment for a house, pay medical bills or insurance, or if you pass away or have a disability. If you take advantage of one of the considerations with a Traditional IRA then you will most likely get the 10% penalty waived but you will have to pay taxes on each distribution.