A Roth IRA can be a great way to stash away money for your retirement. Like all tax-advantaged retirement plans, however, the IRS has rules and requirements governing how they can be used. These include rules regarding the taxation of contributions and withdrawals. There are also limits on how much you can contribute in a given year, as well as income limits for participating in these plans. Understanding how these rules impact your retirement savings can have a major impact on your retirement plans.
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What Is a Roth IRA?
Like a traditional IRA, a Roth IRA is a retirement account you open yourself at a brokerage. Where they differ, though, is in their tax treatment. Traditional IRAs are tax-deferred, which allows for a tax deduction, while Roth IRAs are funded with after-tax dollars. As a result, you can’t deduct your Roth IRA contributions from your taxable income.
The major benefit of a Roth IRA is that you can make tax-free withdrawals once you retire. While there’s no upfront deduction while you’re saving, your after-tax contributions grow and compound over time, and then can be withdrawn with no income taxes whatsoever.
2021 Roth IRA Income Limits and Contribution Limits
There are income limits on Roth IRAs, and your income will determine your eligibility for them. Depending on where you fall within the limit range, your contribution limit may be affected.
For 2020, the Roth IRA contribution limit is $6,000, which is the same amount as the traditional IRA limit. If you’re 50 or older, you’re allowed to contribute up to $1,000 more, making the over-50 contribution limit $7,000. If you’ve hit the Roth IRA contribution limit, you can also consider contributing to a Roth 401(k).
Here are the 2020 Roth IRA income limits based on your modified adjusted gross income and tax filing status:
- Single, Head of Household and Married Filing Separately (didn’t live with spouse in 2021)
- Contribute up to the limit if your income is less than $125,000
- Contribute a reduced amount if your income is $125,000 to $140,000
- Ineligible for contributions if your income is $140,000 or more
- Married Filing Jointly and Qualifying Widow(er)
- Contribute up to the limit if your income is less than $198,000
- Contribute a reduced amount if your income is $198,000 to $208,000
- Ineligible for contributions if your income is $208,000 or more
- Married Filing Separately (did live with spouse in 2021)
- Contribute a reduced amount if your income is less than $10,000
- Ineligible for contributions if your income is $10,000 or more
Let’s say your income makes you ineligible for a Roth IRA. You can still take advantage of what’s called a backdoor Roth IRA. With this, you contribute to a nondeductible traditional IRA and then roll it over into a Roth IRA.
Roth IRA Tax Rules in Retirement
Since the money you contribute to your Roth IRA is after-tax money, you don’t have to pay taxes again when you start taking distributions from the account in retirement, provided you have had the Roth IRA for at least five years and have hit age 59.5. Tax-free withdrawals make the Roth IRA a great way to diversify your tax risk in retirement.
If you have a 401(k) through work, you’ll pay taxes on that money when you start taking distributions in retirement. Opening a Roth IRA on the side will give you both a pre-tax retirement account and a post-tax account. If you’re not sure if you’ll be in a higher or lower tax bracket in retirement, having both types of accounts allows you to hedge your bets.
The younger you are when you open your Roth IRA, the more you stand to gain. You’ll benefit from the magic of compound interest, and from more years of gains that are never taxed. Plus, most people make less money when they’re younger, which means the tax they pay on those contributions are likely lower.
Making Roth IRA Withdrawals Before Retirement
With a traditional IRA, you’ll pay a penalty if you take withdrawals before you hit age 59.5. With a Roth IRA, though, you can withdraw your contributions at any time without paying a penalty. Keep in mind that you can only withdraw up to the amount you contributed. You can’t withdraw earnings until you hit 59.5. That means you’ll need to keep track of how much you contribute to your Roth account, or risk withdrawing too much and paying for it.
There are a few instances in which you can withdraw earnings without paying a penalty. You won’t pay a penalty if you’re withdrawing funds because of a disability. The IRS defines being disabled as being unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long continued and indefinite duration.
Other exceptions include:
- If you die.
- If you start a SEPP program.
- Paying for medical expenses that account for more than 7.5% of your adjusted gross income (AGI).
- Paying medical insurance premiums while receiving unemployment for more than 12 weeks.
- Making your first purchase of a home.
- Paying for qualifying higher education expenses.
Other Roth IRA Rules
Traditional IRAs come with required minimum distributions, or RMDs. This means when a traditional IRA account holder reaches age 70.5, they’re required to start taking a certain amount of money out of their account. This is true even if they don’t need that money and don’t want to pay taxes on it.
On the other hand, Roth IRAs do not require RMDs. So if you don’t need the money right away in retirement, you can let it keep growing tax-free until you do. This can add much more flexibility into your long-term plans.
Not only can you leave your money in a Roth IRA well into retirement, you can even keep contributing. With a traditional IRA, you must stop making contributions at age 70.5. Roth IRAs come with no such rule. In turn, you can continue contributing to it for as long as you live, making them valuable assets for those who want to build up wealth to transfer to their heirs.
The Roth IRA can be a great retirement savings option for anyone who wants to reduce his or her tax burden in retirement and benefit from years of tax-free growth in the meantime. If you think you’ll be in a higher tax bracket in retirement than you are now, saving in a Roth can be a particularly smart move.
Not sure how your tax bracket will compare in retirement? We get it. No one can predict with 100% certainty what tax policy changes lie ahead. But if you’re already contributing to a tax-deferred account like a 401(k), it might be a good idea to hedge your bets with a Roth. And even if your effective tax rate does wind up being lower in retirement, the benefits of decades of tax-free growth might still make a Roth worth it.
Tips for Saving for Retirement
- A financial advisor can help you determine the best route to reach your retirement goals. SmartAsset’s free financial advisor matching tool can connect you with up to three advisors in your area in just five minutes. Get started now.
- Before you start contributing to an IRA, max out any employer matches offered through your 401(k). In every sense of the word, employer matching is free money, so don’t pass it up.
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