Roth Individual Retirement Accounts

Potential for tax-free investment income using Roth IRA

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What is a Roth IRA?

A Roth IRA is a type of individual retirement savings account -- similar to traditional IRAs and 401(k) plans. Like other retirement savings plans, investment income inside the Roth IRA is not taxed as the income is earned, and there are penalties for taking money out early from the plan. What is distinctive about Roth IRA accounts is that money inside the plan can potentially be withdrawn entirely tax-free, as long as certain conditions are met.

Because of the potential to accumulate tax-free investment income, Roth IRAs present a unique tax planning opportunity for savers and investors.

Roth IRAs provide potentially tax-free savings and distributions. Unlike a traditional IRA, you don't get a deduction for your contributions. Instead, savings grow inside of the Roth IRA without needing to pay any taxes on the earnings and growth. Distributions from a Roth IRA are completely tax-free, as long as you meet certain conditions. You may be able to contribute to a Roth IRA even if you are covered by a retirement plan at work. Be aware that Roth IRAs do have income restrictions regarding who can fund a Roth.

Tax Benefits and Disadvantages of a Roth IRA

Unlike traditional types of retirement plans, there is no tax deduction for contributing funds to a Roth IRA plan. Instead, withdrawals (also called distributions) from a Roth IRA account are tax-free as long as certain conditions are met.

Essentially, a Roth IRA is a post-tax savings vehicle (in contrast to the pre-tax or tax-deductible retirement plans).

The main disadvantage of a Roth IRA is that the savings inside the Roth are tied up until you reach age 59.5 years old. There are some exceptions allowing you to withdraw funds earlier.

Absent any exceptions, an early distribution from a Roth IRA will be subject to a 10% federal tax penalty and any earnings withdrawn would be taxable.

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 free of federal taxes.
+ Roth IRAs do not have mandatory minimum distributions.
+ Roth IRAs can be bequeathed to heirs and thus can 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 all your Roth IRAs, which might not always prove advantageous.

How much savings can be contributed to a Roth IRA?

The maximum amount that can be contributed to a Roth IRA is $5,500 for 2015 and 2014.

People age 50 or older can contribute an additional $1,000 to their Roth IRA as a catch-up contribution.

This limit applies to both Traditional and Roth IRAs collectively. You can contribute to both a Traditional and a Roth IRA if you want, but the combined total cannot exceed the maximum for a given year.

If you do exceed the maximum, you will need to correct the problem by taking a corrective distribution before the due date of your return.

Contribution Limits to a Roth IRA based on Income

The contribution limit represents the maximum that can be contributed per year. A person's actual Roth IRA contribution limit can be further reduced or eliminated depending on their income level for the year.

One limit is called the earned income limit. You can contribute up to the lower of 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.

A second limit is for higher income people. This limit, based on a person's modified adjusted gross income for the year, determines how much (if any) can be contributed to a Roth IRA.

Roth IRA Eligibility Phased out based on Modified AGI
Filing Status20142015
 fromtofromto
Single$114,000$129,000$116,000$131,000
Head of Household114,000129,000116,000131,000
Married Filing Jointly181,000191,000183,000193,000
Qualifying Widow/er181,000191,000183,000193,000
Married Filing Separately*-0-10,000-0-10,000
Source:IR-2013-86IR-2014-99

* If the spouses live apart from each other all year, they can use the income limits for single people instead for determining their eligibility for a Roth IRA.

There are three possible outcomes:

  • if modified AGI is less than the "from" amount, the person can contribute up to the full amount in a Roth IRA;
  • if modified AGI is between the "from" and the "to" amounts, the amount a person can contribute to a Roth IRA is limited (or phased out), which is calculated using Worksheet 2-2 in Publication 590;
  • if modified AGI is over the "to" amount, then the person is not eligible to contribute to a Roth IRA for that year.

Criteria for Tax-Free Roth IRA Distributions

Funds withdrawn from a Roth IRA will be completely tax-free as long as the following criteria are met:

  • The distribution is made after five years from the date when you first began contributing to a Roth IRA; and
  • The distribution is made after you reach age 59.5 years old, or because you are disabled, or paid to a beneficiary after your death, or to purchase a home for the first time.

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

Tax Treatment for Non-Qualifying Distributions from a Roth IRA

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

Converting funds from other retirement accounts to a Roth IRA

Tax-deductible funds from a traditional IRA or 401(k) or similar pre-tax savings plan can be converted to a Roth IRA. Converting to a Roth means undoing the tax-deferral by paying tax on the accumulated earnings and on any savings contributions for which the person took a 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.

Using the Conversion Rules to Fund 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 and then later convert that traditional IRA to a Roth.

Reference Material on the IRS Web site