What’s a Roth IRA?
The IRA types include both Roth and traditional IRAs. A Roth IRA is an individual retirement account that allows you to make after-tax contributions. Traditional IRAs are individual retirement accounts that offer a tax-advantaged way for individuals to save for retirement.
Nearly any employed person is allowed to open a traditional IRA. Whether the contributions will be tax deductible and the amount of the deduction will be determined by several factors, including the following:
- Tax filing status
- Whether you are covered under an employer-sponsored retirement plan
- Your modified adjusted gross income
What are some of the Roth IRA rules?
The Roth IRA rules that apply to you will depend on several factors, including your age, if you are covered under an employer-sponsored retirement plan, or if you are going to direct your account and your investment goals. Since Roth contributions are made on an after-tax basis, your savings can grow tax-free. When you withdraw them in retirement, you will not have to pay tax on your withdrawals.
The best IRA types are the ones that are the most tax-efficient for you. If you expect that your income in retirement will be higher than your current income, a Roth may make more sense. If you expect that your income in retirement will be lower in retirement than it is currently, a traditional IRA may make more sense.
Retirement savings and Roth IRAs
According to the Investment Company Institute, approximately 33% of people who have IRAs have Roth accounts. Three out of 10 people who have Roth accounts are younger than age 40. The Tax Foundation reports that nearly half of people who made contributions to IRAs had incomes under $100,000.
While 35% of workers reportedly have at least $100,000 in retirement savings, 38% have less than $10,000 in savings. Choosing the right IRA types may help people to save more for retirement so that they can be more comfortable in the later years.
Roth IRA rules
It is important to understand the Roth IRA rules before you open an account. Under the Roth IRA rules, there is not an age limit on who can open or can make contributions to a Roth account. If you are working, you are able to contribute to your Roth account.
If your spouse works while you complete unpaid work caring for young children or for elderly parents, you can open a spousal Roth or a spousal IRA. These work like individual IRAs and have similar contribution limits. For spousal IRAs, the working spouse contributes to the IRA on behalf of the non-working spouse.
The Roth IRA contribution limits 2019 are $6,000 if you are younger than age 50 or $7,000 if you are age 50 or older. These limits may be the taxable compensation that you earned in the year if it was less than the Roth IRA contribution limits.
In addition to the Roth IRA contribution limits 2019, there are some other rules that you should know. The contributions that you make to your Roth account are made after you pay taxes. This means that you cannot take a tax deduction for your contributions, but your investment can grow tax-free.
When you take distributions, you will not have to pay taxes on them. In some cases, distributions from these IRA types can be taken before retirement. A qualified distribution is one that follows both of these two rules:
- The distribution is taken at least five years after the date that you opened the Roth account
- You are at least 59 1/2 when you withdraw the funds
There are other circumstances that warrant a qualified distribution. You may take out $10,000 or less to rebuild or buy a first home for yourself, your child, or your grandchild. Other situations include If you have become disabled or the distribution is made to your estate after your death.
Unlike traditional IRAs and employer-sponsored plans, there are no required minimum distributions beginning after you turn age 70 ½ from a Roth account. You are able to withdraw your contributions to a Roth account at any time without paying a penalty. However, you cannot withdraw the interest that you have earned on your contributions.
If you inherit a Roth account that was less than five years old when the original owner died, you will owe taxes on the earnings that you withdraw.
Roth vs. traditional IRA
|Features||Roth IRA||Traditional IRA|
|Contribution limits||$6,000 if under 50 or $7,000 if older than 50||$6,000 if under 50 or $7,000 if older than 50|
|Contributor’s age||No age limits for the contributors||Cannot make contributions after you reach age 70 1/2|
|Income limits||Yes, income caps may prevent people from contributing||No income limits|
|Deductions||Contributions cannot be deducted||Contributions may be deductible|
|Tax credits||Can be used for the saver’s tax credit||Can be used for the saver’s tax credit|
|Tax deferrable?||Earnings grow tax-deferred, and distributions are tax-free||Earnings grow tax-deferred, and distributions are taxed at withdrawal based on the regular income tax rate|
|Early withdrawal penalties||Distributions may be taken at any time, and qualified distributions are tax- and penalty-free||Distributions may be taken at any time. If the person is younger than age 59 1/2, the distributions may be subject to an early withdrawal penalty in addition to being taxed|
|Required minimum distributions||None||Beginning after you reach age 70 1/2|
Roth conversion or backdoor Roth IRA
The Roth IRA income limits prevent some people from being able to make contributions to a Roth account. The income limits for single taxpayers are $137,000 with the phaseout of the ability to make contributions starting at $122,000. Whereas, the limits for married taxpayers are $203,000 with the phaseout of the ability to make contributions starting at $193,000.
Because of the Roth IRA income limits, some taxpayers are unable to contribute to Roth accounts. However, they may be able to do so by creating a backdoor Roth IRA. This is when you convert a traditional IRA to a Roth account. Since there are no income limits to make traditional IRA contributions, you can open a traditional IRA and contribute to it. You can then convert it into a Roth account to create what is referred to as a backdoor Roth IRA.
When you complete a Roth conversion from a traditional IRA to create a backdoor Roth IRA, you will pay income tax on the contributions at the time of your Roth conversion. The taxable amount of the amount that you convert will be added to your income taxes. Your regular income rate is applied to your total income. If the conversion is done properly, you will not be subject to a 10% early withdrawal penalty and will have successfully created a backdoor Roth IRA.
There are no income limits for conversions, which is why taxpayers who exceed the Roth IRA income limits are able to create backdoor Roth IRAs. You are able to make a non-deductible IRA contribution and then to immediately roll it over into a Roth account.
Under the Roth IRA rules, there are some limitations you should be aware of when considering conversion. You are not allowed to recharacterize the account once you have completed a conversion. You are not able to convert required minimum distributions to a Roth account. Under the Roth conversion pro-rata rule, the tax-exempt part of your rollover contribution can only constitute a pro-rata share of the total amount that is rolled over.
If you have started taking substantially equal periodic payments from your traditional IRA, you are allowed to convert those amounts to your Roth IRA as you receive them. The payments will be taxable, but the 10% early withdrawal penalty will not apply.
How to complete a Roth conversion
In order to do a Roth conversion, start by making contributions to a traditional IRA. Pay taxes on your contributions and earnings. Only post-tax dollars will be eligible to convert to a Roth account. If you claimed deductions for the contributions that you made to your traditional IRA, you will have to pay them back. Your contributions and any gains that you earned will be added to your taxable income when you file your annual tax return for the year.
You can then convert to a Roth in one of three ways. In a 60-day rollover, you take the funds directly from your traditional IRA by a check that is made payable to you. You then roll them over into a Roth account. The deposit into the Roth account must happen within 60 days of the distribution. If you do not deposit the funds within 60 days, the amount of the distribution will be taxable in the year that it was taken, there will be no conversion and you be assessed a 10% early distribution tax penalty.
The second way that you can complete a conversion if your income exceeds the Roth IRA income limits is a trustee-to-trustee transfer. This is also the easiest way to complete the process. The trustee of your traditional IRA sends your funds directly to the trustee of your Roth account.
Finally, you can complete a same-trustee transfer. With this type of transfer, your money stays in the same institution. You set up a Roth account with the traditional IRA trustee and tell him or her to move the money from the traditional IRA to your Roth account.
You should convert to a Roth during a year when you fall in a lower tax bracket than normal and when your traditional IRA account balance is down. You should also complete the conversion early in the tax year since you will not have to pay the taxes until April of the following year. This will give you more time to pay the taxes for your converted amounts so that they can be more affordable.
There are several reasons to convert to a Roth, including the following:
- Investment earnings grow tax-free
- Can lower your taxable income in retirement
- Your tax rate in retirement may be higher than it is now
- No required minimum distributions after you retire
- The ability to continue contributing to the Roth after age 70 ½
- Tax-free withdrawals in retirement
- No income limits for converting to a Roth account
You should not convert to a Roth if the conversion will raise you into a higher marginal tax bracket during the year of the switch or if you cannot afford the tax payments that will be generated by the conversion.
You should also not convert your account if you will need the money in the next five years. Any distributions of your earnings and rolled over amounts risk being hit with income taxes and the 10% early withdrawal penalty if you withdraw them before five years have elapsed.
If you are 70 ½ or older, you must take your required minimum distribution before you can convert your traditional IRA to a Roth account. It is always advisable to check in with a tax accountant to make sure your strategy is within the rules.
IRA rollovers to Roth accounts
IRA rollovers to Roth accounts occur when you take funds from an employer-sponsored retirement account and roll them into a new IRA. Roth accounts can only be rolled over to other Roth accounts.
You are only allowed to complete a rollover from an IRA to another IRA once during any 12-month period. All of your IRAs will be aggregated when considering the limit and will be treated as a single IRA. There is no limit on trustee-to-trustee transfers or on conversions of traditional IRAs to Roth IRAs.
Inherited Roth IRA
If you inherit a Roth IRA, you are able to withdraw the contributions tax-free at any time as long as you adhere to the five-year rule. According to the IRS, Roth IRAs do not require withdrawals until after the death of the owner. The sole spousal beneficiary of a Roth IRA will not be required to start taking minimum distributions at any time.
If you are a non-spouse beneficiary or are a spouse who is not the sole beneficiary of a Roth IRA, you will be able to postpone distributions only until the original account holder would have turned 70½, or Dec. 31 of the year following the year of death, whichever is later.
Borrowing from a Roth IRA
The IRS rules state that you cannot use your IRA to fund a loan to yourself or to use the balance of the account as collateral. The IRS classifies borrowing from an IRA or using it as collateral as prohibited transactions.
Steps to open a Roth IRA
To open a Roth account, start by checking your eligibility. Research where to open your accounts such as with a bank, brokerage, or a financial advisor. You should also research the fees that will be charged to open or to maintain your account. Compare whether the customer service is available online or by telephone.
Look at the investment choices that are offered such as ETFs, actively managed funds, stocks, or bonds. Consider the trading costs and the frequency of buying or selling. Once you have determined where to open your Roth, you can do so by opening an account online or by filling out paperwork. Decide how you will invest, including through a broker, robo-advisor, or yourself. Schedule monthly or annual deposits. Finally, check on your account as needed for maintenance.
Why you would want to open a Roth IRA
A Roth IRA is a type of IRA that allows you to make post-tax contributions. Your investments can grow tax-free, and you will not be taxed on your withdrawals in retirement. You can avoid the income limits if your income is too high by converting a traditional IRA to a Roth account. Since the Roth contribution deadline is the tax deadline for the following year you have more time to count the contributions for the previous tax year.
Opening a Roth IRA can offer you multiple benefits. M1 Finance can help you unlock maximize those benefits.
Keep more of your Roth IRA at M1
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