Understanding Roth IRAs
An individual retirement account (IRA) is a common retirement savings account held through an independent third-party custodian that offers unique tax incentives. There are generally two types of IRAs: a traditional and Roth. A Roth IRA is a retirement account that offers a different tax benefit than a traditional IRA. Unlike a traditional IRA, your contributions to a Roth IRA are not tax-deductible. However, if you meet the Roth IRA distribution rules, earnings on those contributions are not taxed. Compare that to a traditional IRA where you may receive a deduction on contributions, but withdrawals during retirement are taxed as ordinary income.
The types of investments allowed within IRAs vary depending on the custodian; most custodians only allow approved stocks, bonds, mutual funds, exchange-traded funds and certificates of deposit. However, with self-directed IRAs (which can be traditional or Roth), the custodians allow for a broader spectrum of investments including real estate, private placements, non-listed REITs, gold, commodities contracts, options and futures.
What are the main characteristics of a Roth IRA?
- To contribute to a Roth IRA, you must have taxable compensation and your modified gross adjusted income must below certain amounts. For 2021, the phase-out starts at $125,000 and ineligibility after $140,000 for single filers; for those that are married and jointly filing, phase-out starts at $198,000 and ineligibility after $208,000.
- For 2021, you can contribute up to $6,000 each year ($7,000 if you’re 50+). Unlike traditional IRAs, contributions to a Roth IRA are not eligible for a tax deduction.
- You can contribute to a Roth IRA (subject to the eligibility requirements above) even if you are participating in a 401(k), 403(b), or 457 plan.
- There is no age limit on making contributions to a Roth IRA.
- Roth IRAs are not subject to lifetime Required Minimum Distribution (RMD) rules since distributions are not required during the lifetime of the owner. This means that the account can accumulate and be passed to beneficiaries.
- If your contributions have been in your Roth IRA for at least five years, you can withdraw income tax and penalty free if:
- You’re 59½ or older. Meaning all withdrawals, whether they’re of earnings or contributions, are income and penalty free.
- If you’re not yet 59½, you can withdraw the principal (i.e. your contributions) tax and penalty free, but any withdrawal of earnings on the principal would be included as income and be subject to a 10% early withdrawal penalty.
- You become permanently disabled.
- You pass away and a beneficiary takes the distribution
- You’re buying your first home. This qualified first-time home purchase exception is limited to $10,000 and the money must be used towards your first home purchase within 120 days of receiving the money.
- If your contributions have not been in your Roth IRA for at least five years, you can still withdraw the earnings penalty free, but not income tax free, if funds are:
- Used to pay unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI) for the year.
- Used to pay insurance premiums while you’re unemployed and have received unemployment compensation for more than 12 weeks.
- Used to support you after you become permanently and completely disabled.
- Used for qualifying higher education for you, your spouse, your children or your grandchildren.
- Part of a series of substantially equal payments over your life (or your life expectancy), or over the lives (or the joint life expectancies) of you and your beneficiary. An IRS-approved distribution method must be used and at least one distribution must be taken annually for this rule to apply.
- Used to buy your first home. This qualified first-time home purchase exception is limited to $10,000 and the money must be used towards your first home purchase within 120 days of receiving the money.
- Part of an IRS levy, a qualified reservist distribution, a qualified disaster recovery assistance distribution or qualified recovery assistance distribution.
- Made to the beneficiary of your estate after your death.
What’s the catch?
Those with income above a certain level are not eligible to contribute to a Roth IRA.
The amount you can contribute to a Roth IRA begins to shrink at certain thresholds based on your modified adjusted gross income (MAGI), and keeps shrinking as income rises until your ability to contribute is eliminated completely. For 2021: phase out starts at $125,000 and ineligibility after $140,000 for single filers and for married filing jointly (and qualifying widow(er)) filers, phase-out starts at $198,000 and ineligibility after $208,000. This is slightly higher than 2020 where single filers, phase-out started at $124,000 and ineligibility at $139,000, and for married filers phase-out started at $196,000 and ineligibility at $206,000.
What if you want a Roth IRA but are ineligible to contribute to one because you earn too much? A backdoor Roth IRA allows you to get around the income limits by converting a traditional IRA into a Roth IRA; most custodians providing both types of IRAs will assist with this strategy. However, while this allows you to have and own a Roth IRA (with all the benefits mentioned above), the process of converting may have tax consequences that you must be aware of and carefully plan for with your tax advisor. When converting a traditional IRA to a Roth IRA, you’ll need to pay taxes on any money in your traditional IRA that has not already been taxed. This means that the amount you’re converting may be included in your income in the year of conversion and may push you into a higher tax bracket. Given this, you may want to consider this strategy in a year when your income happens to be unusually low. To make the most of this strategy, consult your tax advisor.
If your tax bracket is likely to be lower at the time of the investment than at the time of the distribution, Roth IRAs may be more attractive to you because you will only pay taxes at your current income level. Once distributions start, you will not pay any taxes on earnings, even if you are in a higher tax bracket at the time of distribution. As with all investment vehicles, there are certain rules and limitations to Roth IRAs and a qualified tax professional will be best equipped to evaluate each individual investor’s options for retirement investing.
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