Retirement is the time people set apart for all the things that they couldn’t do during their professional lives. It could be vacations, taking a new habit, or buying a boat for month-long cruises.
However, what most people don’t realize when planning these activities is the impact of federal and state income taxes on their withdrawals. Failing to invest in tax-efficient instruments is one of the most common mistakes we witness when analyzing retirees’ portfolios.
At DollarGeek, we recommend individuals to choose tax-efficient retirement planning tools for retirement savings.
Roth IRA is one of the most popular retirement plans among people. This guide will help you understand Roth IRAs, their different types, contributions, and regulations surrounding these retirement accounts.
What is a Roth IRA?
A Roth IRA is a tax-advantaged retirement plan that allows participants to contribute after-tax dollars to their account. Plan participants pay the taxes upfront, which allows them to withdraw their contributions, earnings tax-free in the future, after reaching the qualified retirement age.
Roth IRAs have strict income limits for eligible contributions. On the other hand, they offer some unique benefits, such as tax-free withdrawals, no required minimum distributions, and the ability to contribute as long as you wish, even after age 70 ½.
How does a Roth IRA work?
- Open a Roth IRA: The first step is to open a Roth IRA account with an IRS-approved financial institution. It can be a bank, credit union, or an online broker. Our team has put together a list of some of the best Roth IRA providers after taking into account multiple factors.
- Fund your Roth IRA: Once your Roth IRA is active, the next step is to fund it through qualified contributions. There are multiple options to fund your Roth IRA, including regular contributions, transfers, conversions, rollover conversions, and spousal IRA contributions.Although, you must understand that you can only contribute earned income to a Roth IRA. It could come from a job or a business. You cannot contribute child support, unemployment benefits, investment income from rental property, securities, or other assets to your Roth IRA.
- Invest your Roth IRA funds. Now that your Roth IRA has retirement funds, you can start investing them into different types of assets. When it comes to investments, your choices may vary from one financial institution to another. Most traditional institutions stick with conventional options, including stocks, bonds, mutual funds, with limited discretion. As the Roth IRA participant or plan holder, make sure to choose a Roth IRA account that provides multiple investment options.
- Withdrawal rules for Roth IRA: One of the first rules that we want to touch on is the absence of required minimum distributions for Roth IRA. Additionally, there are no restrictions on withdrawing your contributions from a Roth IRA, since you’ve already paid the taxes.
However, when you withdraw earnings from your Roth IRA before 59½, your withdrawals are subject to income taxes as well as a 10% withdrawal penalty. Also, there is a 5-year rule for Roth IRAs that we’ll discuss in detail in the next section.
Roth IRA: Contributions, withdrawals, tax treatment
Roth IRA Contributions
Your contributions to a Roth IRA depends on your net income and tax-filing status. The IRS has set precise income levels based on your MAGI (modified adjusted gross income). As per the contributions limits of 2021, you can contribute a maximum of $6,000 to a Roth IRA, along with a catch-up contribution of $1,000 if you’re over 50.
Let’s take a look at the income limits for Roth IRA.
|Filing status||MAGI for 2021||Roth IRA Contribution limit|
|Single||Under $125,000||$6,000 + $1,000 for 50 or above|
|$125,000 to $140,000||Contributions start phasing out.|
|Above $140,000||No contributions allowed|
|Married filing jointly||Under $198,000||$6,000 + $1,000 for 50 or above|
|$198,000 to $208,000||Contributions start phasing out.|
|Above $208,000||No contributions allowed|
|Married filing separately||Under $10,000||Contributions start phasing out.|
|Above $10,000||No contributions allowed|
You can find out more about 2019 contribution limits by referring to the IRS Publication 590-A.
Roth IRA Withdrawal Rules
Roth IRA has different withdrawal rules from a traditional IRA.
First, there are no required minimum distributions for a Roth IRA, making it an excellent retirement savings account for people who want to continue contributing to their retirement plan.
When it comes to withdrawals, the IRS allows withdrawal of contributions at any stage without any penalties or taxes, but the withdrawal rules on earnings are somewhat different.
But first, let’s talk about the 5-year rule for Roth IRAs. Your withdrawals are tax-free and penalty-free if your Roth IRA is five years or older, and you’re above 59 ½ years.
Here is a table to understand Roth IRA withdrawal rules better.
|Age of account holder||5-Year Rule||Applicable taxes or penalties on withdrawals|
|Less than 59 ½ years||Yes||Income taxes plus 10% penalty on earnings, unless you have a qualified exception to avoid both|
|Less than 59 ½ years||No||Income taxes plus 10% penalty on earnings, but chances of avoiding penalty in case of a qualified exception|
|Older than 59 ½ years||Yes||No taxes or penalties|
|Older than 59 ½ years||No||Tax on earnings without any penalty|
Understanding the different types of Roth IRAs
We have already discussed that Roth IRAs have strict contribution rules, but there are some variants of Roth IRAs that provide some flexibility in terms of the contribution limits.
- Backdoor Roth IRA: A backdoor Roth IRA involves converting your existing traditional IRA or 401k plan into a Roth IRA. The IRS doesn’t have any restrictions on who can convert a traditional IRA into a Roth IRA, so it becomes an excellent opportunity for high-income earners. The first option is to roll over your traditional IRA into your Roth IRA by transferring a portion of your IRA account. Another choice is to convert your entire IRA into a Roth IRA. The last option involves making after-tax contributions to a 401(k) and then rolling over those funds into a Roth IRA.However, do understand that you’ll have to pay the due taxes on your IRA funds and any earnings you had before converting it into a Roth IRA.
- Spousal Roth IRA: Another option for individuals with higher income to contribute after-tax funds to a retirement account is through a spousal Roth IRA. You can make full contributions to the Roth IRA of your spouse, even if they don’t have any earned income. However, you’ll need sufficient earned income to contribute to your IRA as well as the Roth IRA of your spouse. Also, you’ll have to pay taxes upfront on these contributions.
Pros and cons of a Roth IRA
Pros of a Roth IRA
- Tax-free growth: Your contributions grow tax-free in a Roth IRA. Any earnings your investments generate qualify for a tax break too. It can be a tax-efficient strategy for people who except higher income during retirement.
- No required minimum distributions: With a Roth IRA, you don’t have to take required minimum distributions. You can keep your savings for as long as possible, allowing them to grow further.
- Ability to withdraw contributions: Since you pay taxes upfront, you can withdraw contributions from your Roth IRA without having to pay any taxes or penalty, although rules for withdrawing earnings are different.
Cons of a Roth IRA
- No tax deduction: If you’re trying to lower your taxable income, Roth IRAs do not offer any relief, as you have to pay the taxes upfront.
- Lower contributions: The IRS has set low contribution limits for Roth IRAs, allowing you to contribute only $6,000 (or $7,000 of above 50) annually.
- Strict income limits: The IRS has strict income limits for Roth IRAs. Also, you need to have earned income in order to contribute to a Roth IRA.
Roth IRAs are a little more complicated than a traditional IRA. You may find it challenging to choose the right provider. DollarGeek has put dozens of manual hours in comparing different Roth IRA accounts.
Here are some of the best Roth IRA account providers in the market.
The bottom line
Roth IRAs offer tax-diversification during retirement. They should be a part of your retirement strategy. Not only do they offer tax-free growth of your investments, but you don’t have to worry about these contributions affecting your tax bracket during retirement.