I’m sure you’ve heard of a Roth IRA or Roth 401k from friends, family, work benefit packages or even online when you’re researching retirement accounts to invest in. Established through the Taxpayer Relief Act of 1997, Roth IRAs have become increasingly popular ever since. I know when I graduated from college in the 2000s and started earning some income, it was the first investment account that I opened for myself.
What is a Roth IRA and are you eligible to have one? After reading this post, you will gain the insight needed to determine if a Roth IRA is right for you.
A Roth IRA, What?
Ok, so first things first, what is a Roth IRA? Simply put, a Roth IRA is an investment account generally used for retirement named after one of the Senators who co-sponsored its legislation (Senator William Roth). It is like a traditional IRA, but with a few twists:
- Contributions are not tax-deductible – invest with your money after it has been taxed.
- Money contributed to a Roth IRA (principal) are always withdrawn tax and penalty-free.
- Earnings withdrawals are tax free at age 59 ½ if you have also owned the Roth IRA for 5 years.
- Transactions inside a Roth IRA (dividends, capital gains, etc.) are also tax-free.
Other Qualified Distributions (earnings withdrawals not taxed) include:
- Qualified higher education expenses;
- First-time homebuyer (up to a $10,000 lifetime limit);
- Distribution is part of a series of substantially equal payments,
- Unreimbursed medical expenses over the IRS minimum threshold; and
- Paying medical insurance premiums during unemployment.
For all of the details, and a full list of qualified distributions, see the official IRS publication: Roth IRAs. What if your withdrawal doesn’t meet the above qualifications? Then, it may be subject to tax and to the 10% additional tax.
How do I Contribute to a Roth IRA?
For 2017, Roth IRA annual contribution limits are $5,500 per individual, $6,500 for individuals aged 50 or older.
- First, check your employer provided qualified plan. Many employers now offer (on top of your regular 401k/403b/457b plan) an additional Roth option. If they do, you can directly contribute up to the limit.
- You can directly contribute to a Roth IRA if you meet certain modified adjusted gross income (MAGI) thresholds. These threshold limits vary based on filing status and employer retirement plan activity. For example, let’s assume you are married filing jointly. If your MAGI is less than $186,000, then you can contribute the maximum. However, as your MAGI increases, your allowed contribution gets reduced (final phase out is at $196,000). Here is the link to the official IRS table: MAGI Limits for Direct Contributions. Please note due to cost of living adjustments, see official notice Increases to Contribution Limits, the limits in the table will be slightly off. The calculation, however, remains the same.
Wait, Can I Contribute?
At this point in the post, you might be thinking, I’ve read this far into the post just to find out that I can’t actually contribute to a Roth IRA? The answer is – if the above two ways aren’t an option for you – there are still options available.
So, what are these possible options for you to contribute to a Roth IRA, you ask – Roth transfers and conversions!
- Employer qualified plan doesn’t have a Roth option, but does allow for after-tax contributions. If you utilize this option, you can generally transfer (annually most of the time) this amount out of the plan (and into a Roth IRA) tax-free.
- Transfers from a tax deferred retirement account (IRAs and 401ks). You are allowed to move your pre-tax money from these accounts as well. However, since you did not pay taxes on this yet, it creates a taxable transfer. It is typically recommended to use this strategy in carefully calculated amounts in years you do not have a lot of taxable income (i.e. early retirement years).
- Utilize what we like to call a “Roth two-step” process. First, do a Roth conversion from IRAs (so there is no taxable IRA money). Then, each year, you would make a non-deductible IRA contribution (so use after tax money), then immediately convert this to a Roth IRA.
A lot of information to digest – I know – but hopefully this post has armed you with the information that enables you to take advantage of utilizing Roth IRAs.
In conclusion, and while I’ve got you thinking, here are some of the advantages of Roth IRAs:
- Withdrawals are tax-free (if utilized properly – 5 years AND 59 ½, unless a qualified distribution).
- Accumulating Roth money for retirement is a great way to help balance taxable income during retirement.
- Utilize Roth IRAs as part of your college savings planning, or to help with buying a home.
- No required minimum distributions forced on you at age 70 ½ – if you don’t want to withdraw money, you don’t have to.
- You can contribute as long as you have earned income (you don’t have to stop once you turn 70 ½).