Roth Individual Retirement Accounts

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

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With so many retirement account options available, it's easy enough to feel confused by the fine lines of differences between them. A Roth IRA is a type of individual retirement savings account that's similar to traditional IRAs and 401(k) plans, but a few critical different rules apply. 

Roth IRAs Vs. Other IRAs

Like other retirement savings plans, investment income that's held inside a Roth IRA is not taxed as its earned.

You don't have to report interest or dividends as income on your tax return before you enter retirement. Also like other plans, there are penalties for taking money out early. 

What's distinctive about Roth IRA accounts is that the money can be withdrawn entirely tax-free after you retire if certain conditions are met. That's because you don't get a tax deduction for contributions you make into the account over the years, unlike you would with a traditional IRA. You already paid taxes on your contributions once, at the time you earned the income which you contributed, and the income it earns is not taxed. Roth IRAs present a unique tax-planning opportunity for savers and investors because of their potential to accumulate tax-free investment income.

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 retirement accounts. There are some exceptions that allow you to withdraw funds earlier for certain reasons. Otherwise, an early withdrawal from a Roth IRA is subject to a 10-percent federal tax penalty and any earnings withdrawn would become taxable.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Funds withdrawn from a Roth IRA will be completely tax-free if: 

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

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

Tax Treatment of Non-Qualifying Distributions

Withdrawals from a Roth IRA account that don't meet the criteria of qualifying distributions are partially taxable. Your original contribution to the Roth IRA is returned to you tax-free, but any earnings and growth are fully taxable. The taxable portion of the Roth withdrawal is also subject to the 10-percent early distribution penalty.

How Much Can You Contribute to a Roth IRA?

The maximum amount you can contribute to a Roth IRA is $5,500 annually for 2016 and 2017. People age 50 or older can contribute an additional $1,000 a year as a catch-up contribution.

This limit applies to both traditional and Roth IRAs.

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

Contribution Limits Based on Income

Roth IRAs do have some income restrictions regarding who can fund them. Your actual Roth IRA contribution limit can be further reduced or even eliminated entirely depending on your income level for the year. There are actually two limits: 

  • One first is called 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 only $5,000, that's all you can contribute to a Roth IRA. If it's $30,000, you can contribute up to the $5,500 limit. 
  • The second limit applies to taxpayers with higher incomes. It's based on a taxpayer's modified adjusted gross income 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 Status20162017
 fromtofromto
Single$117,000$132,000$118,000$133,000
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
Source:IR-2013-86IR-2014-99

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

Three Possible Outcomes 

  • If your modified AGI is less than the "from" amount shown above, you can contribute up to the full amount of the contribution limit in a Roth IRA.
  • If your modified AGI 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 modified AGI is over the "to" amount, you are not eligible to contribute to a Roth IRA for that year.

For most taxpayers, their modified AGI is your adjusted gross income plus any tax-exempt interest income reported on lines 37 and 8b of Form 1040 and any above-the-line deductions you 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 did not take any of these tax breaks. 

Converting Funds From Other Retirement Accounts 

Tax-deductible funds from a traditional IRA, a 401(k), 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.

Unlike the Roth IRA contribution limits, there are no income restrictions for converting to a Roth IRA. This creates a tax planning opportunity for higher-income people who are not 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 do not have mandatory minimum distributions, known as RMDs. You're not required to take the money out until you want to.  
  • Roth IRAs can be bequeathed to heirs and can therefore escape both income taxes and estate taxes.
  • Early withdrawals from a Roth IRA can be subject to taxes and penalties.
  • There are income restrictions for being eligible 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.