Roth Individual Retirement Accounts

The Potential for Tax-Free Investment Income Using a Roth IRA

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It's easy to feel confused by the fine lines of differences between retirement plan options when there are so many of them. A Roth IRA is a type of individual retirement savings account that's similar to traditional IRAs and 401(k) plans in several ways, but there are a few critical, different rules.

Advantages of Roth IRAs

Like other retirement savings plans, investment income and growth that remain held inside a Roth IRA isn't taxed as it's earned.

You don't have to report interest or dividends as income on your tax return before you enter retirement and take withdrawals. There are penalties for taking money out early, which is also similar to other plans. 

What's distinctive about Roth IRA accounts is that the money can be withdrawn entirely tax-free after you retire because you've already paid taxes on your contributions at the time you earned the income you invested. You don't get a tax deduction for contributions you make into the account over the years like you would with a traditional IRA. The income your contributions earns isn't taxable, either. Roth IRAs present a unique tax-planning opportunity for savers and investors. 

Another advantage of a Roth is that you might be able to contribute to this type of IRA even if you're covered by a retirement plan at work. This typically isn't the case with other IRAs. 

The savings held inside a Roth IRA are tied up until you reach age 59 1/2, which is also the case with most other retirement accounts.

Some exceptions allow you to withdraw funds earlier for certain reasons, however. Otherwise, however, an early withdrawal from a Roth IRA is subject to a 10% federal tax penalty and any earnings withdrawn would become taxable.

Criteria for Tax-Free Roth IRA Distributions

Funds withdrawn from a Roth IRA will be completely tax-free provided that: 

  • You take the distribution at least five years after the date you first began contributing to a Roth IRA, and
  • The distribution is made after you reach age 59 1/2 or because you're disabled, the distribution was paid to a beneficiary after your death, or you used the money to purchase a home for the first time.

These criteria make a withdrawal from a Roth IRA a "qualifying distribution" for tax-free treatment.

Tax Treatment of Non-Qualifying Distributions

Withdrawals from Roth IRA accounts that don't meet the criteria for qualifying distributions are partially taxable. Your original contribution to the Roth IRA is returned to you tax-free, but any earnings and growth will be fully taxable.

The taxable portion of the Roth withdrawal is also subject to the 10% early distribution penalty.

How Much Can You Contribute to a Roth IRA?

The maximum amount you can contribute to a Roth IRA is $6,000 annually beginning in 2019. Those who are age 50 or older can contribute an additional $1,000 a year as a catch-up contribution. This is an increase from previous years—the first such increase since 2013—although the additional $1,000 increment didn't change. 

These limits apply to both traditional and Roth IRAs.

 You can contribute to both in the same year, but the combined total of your contributions can't exceed the maximum for the year. You must correct the problem by taking a corrective distribution before the due date of your tax return if you exceed the maximum.

Contribution Limits Based on Income

Roth IRAs do have some income restrictions. Your Roth IRA contribution limit can be reduced or even eliminated entirely depending on your income for the year. 

  • The earned income limit: You can contribute up to the contribution limit or your earned income for the year, whichever is less. For IRA purposes only, earned income consists of wages reported on a W-2, self-employment income from a business or farm, and alimony. If your income from all these sources is $5,000, that's all you can contribute to a Roth IRA even though the limit has increased to $6,000 in 2019. If your income $30,000, you can contribute up to the $6,000 limit because your earnings far exceed the maximum contribution. 
  • The second limit applies to taxpayers with higher incomes. It's based on a taxpayer's modified adjusted gross income (MAGI) for the year and it determines how much, if any, of that income can be contributed to a Roth IRA.

Roth IRA Eligibility Phase-Out Based on Modified AGI

Filing Status From:To:From:To:
Head of Household117,000132,000118,000133,000
Married Filing Jointly184,000194,000186,000196,000
Qualifying Widow/er184,000194,000186,000196,000
Married Filing Separately*010,000010,000

You can contribute up to the full amount of the contribution limit in a Roth IRA if your MAGI is less than the "from" amount shown above. 

If your MAGI is between the "from" and the "to" amounts, your contributions to a Roth IRA are limited or "phased out" according to calculations made using Worksheet 2-2 in IRS Publication 590.

If your MAGI is over the "to" amount, you're not eligible to contribute to a Roth IRA in that year.

Most taxpayers will find that their MAGIs are their adjusted gross incomes (AGI) plus any tax-exempt interest income they claimed and any above-the-line deductions they took, but check with a tax professional if you feel like you're close to the "from" limit so you can be sure. Your MAGI and AGI are probably the same if you didn't take any of these tax breaks. 

Spouses can use the income limits for single persons if they lived separate and apart from each other throughout the entire tax year. 

Converting Funds From Other Retirement Accounts 

Tax-deductible funds from traditional IRAs, 401(k)s, or similar pre-tax savings plans can be converted to a Roth IRA, but this means undoing the tax-deferral. You'll pay taxes on the accumulated earnings and on any savings contributions for which you took a tax deduction. This converts the pre-tax funds into post-tax money in the IRA.

There are no income restrictions for converting to a Roth IRA. This creates a tax-planning opportunity for higher-income people who aren't eligible to fully fund a Roth IRA directly. Higher income taxpayers could fund a non-deductible, traditional IRA, then later convert that traditional IRA to a Roth.

A Summary of Tax Benefits and Disadvantages

  • Investment income earned inside a Roth IRA is not reported on your annual tax return.
  • Withdrawals from a Roth IRA can be entirely tax-free at the federal level. 
  • Roth IRAs don't have mandatory minimum distributions, known as RMDs. You're not required to take the money out until you want to.  
  • Early withdrawals from a Roth IRA can be subject to taxes and penalties.
  • There are income restrictions for eligibility to fund a Roth IRA.
  • Losses in a Roth IRA are tax deductible only if you cash out the account out in its entirety, which might not always prove to be advantageous.