How Taxes & Roth Individual Retirement Accounts Work
Tax Benefits and Advantages of the Roth IRA
A Roth IRA is a type of individual retirement account that's similar to a traditional IRA or 401(k) plan in several ways, but with a few critical, different rules when it comes to taxation. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 made a Roth IRA even more attractive for those with eligible incomes.
Advantages of Roth IRAs
Investment income and growth held inside a Roth IRA aren't taxed as they're earned, and this is similar to other retirement savings plans. You don't have to report interest or dividends on your tax return before you retire and begin taking withdrawals. There are penalties for taking money out early, however, which is also similar to other plans.
The money can be withdrawn from a Roth IRA entirely tax-free after you retire because you've already paid taxes on your contributions at the time you earned the income you invested.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 a Roth IRA at the time you make them, however, as you would with a traditional IRA. This provision allows you to take withdrawals tax-free in retirement. The income earned by your contributions isn't taxable, either.
The savings held inside a Roth IRA are tied up until you reach age 59½, which is also the case with most other retirement accounts. Some exceptions allow you to withdraw funds earlier, but you'll pay a tax penalty otherwise.
Rules 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Funds withdrawn from a Roth IRA will be completely tax-free provided that: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 the Roth IRA, and after you reach 59½ or become disabled.
- The distribution is paid to a beneficiary after your death.
- You use 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. Otherwise, an early withdrawal from a Roth IRA is subject to a 10% federal tax penalty and any earnings withdrawn would become taxable.
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 a non-qualifying withdrawal is also subject to the 10% early distribution penalty.
How Much Can You Contribute?
The maximum amount you can contribute to a Roth IRA is $6,000 annually as of 2021. Those who are age 50 or older can contribute an additional $1,000 a year as a catch-up contribution. Unlike a traditional IRA, you can continue to contribute to a Roth IRA after age 70½ or age 72. Your exact age depends on your year of birth.
The limits apply collectively 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 $6,000 or $7,000 maximum.
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 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 up to your earned income for the year, whichever is less. Earned income consists of wages reported on a W-2, self-employment income from a business or farm, and alimony for IRA purposes.
You can only contribute $5,000 to a Roth IRA even though the limit is $6,000 if your income from all these sources is $5,000. But you can contribute up to the $6,000 limit if your income is $6,001 or more, because your earnings exceed the maximum contribution.
The Modified Adjusted Gross Income Limit
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.
|Filing Status||Less Than||Up To|
|Head of Household||$125,000||$140,000|
|Married Filing Jointly||$198,000||$208,000|
|Married Filing Separately* (living together any part of year)||$10,000||$10,000|
You can contribute up to the full amount of the contribution limit in a Roth IRA if your MAGI falls into the "Less Than" amount shown above. Your contributions to a Roth IRA are phased out if your MAGI is between the "Less Than" and the "Up To" amounts. You're not eligible to contribute to a Roth IRA in that year if your MAGI exceeds the "Up To" amount.
Check with a tax professional if you feel like you're close to the "Less than" limit so you can be sure of your MAGI.
An exception to the $10,000 rule for married filing separately taxpayers exists if you didn't live with your spouse at any time during the tax year. Spouses can use the income limits for single taxpayers if they lived separate and apart from each other throughout the entire tax year.
Most taxpayers will find their MAGIs are their adjusted gross incomes (AGI) plus any tax-exempt interest income they claimed and any above-the-line deductions they took.
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 will undo 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.
- 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.