Everything You Need to Know About Roth IRAs

A Roth IRA is an individual retirement account that allows for tax free growth of retirement funds. While you receive no tax benefit or deduction at the time of contribution, you have the opportunity to withdrawal your funds without any taxes due in retirement. In fact, the Roth IRA is one of the less restrictive retirement accounts offered and once you understand how they work and how to use them they can offer many advantages for your retirement savings.

Who can use them?

Roth IRAs are available to anyone at any age with earned income, or a spouse with earned income within a specified income bracket. This differs from Traditional IRAs, where contributions can’t be made after the age 72 when RMDs begin. For 2021 Roth IRA income limits are based on a modified adjusted gross income of $193,000-$208,000 for married filing jointly tax payers and $125,000-$140,000 for single. If your income is below those thresholds you are eligible to contribute to a Roth IRA. If you find your income in the middle of the ranges you can contribute a reduced amount to your Roth IRA and if your income is above you will have to explore other avenues of contributing to a Roth IRA, such the Backdoor Roth IRA method. Roth IRAs are a great tool for people who expect to be in a higher tax bracket in the future or anyone who likes the idea of having some tax-free funds in retirement. You should consult your financial advisor if a Roth IRA is a good tool for your retirement plan.

How much can I contribute?

For 2021 your contribution limits are $6,000 per person, assuming you have at least that much in earnings. If you are over 50 you are eligible for an additional $1,000 “catch-up” contribution. You do have to have reported earned income to be able to contribute and your contribution amount is limited to the amount of earned income. For example, if a single tax payer only has $3,000 of earned income reported on their tax return, their contribution is limited to the $3,000. How much you contribute to your workplace retirement plan such as a 401k or 403b does not affect the amounts you are able to contribute to your Roth IRA.

What happens when I need to take money out?

You can always take out your contributions without fear of tax or penalty. This allows the account to act as a backup emergency fund. This is typically touted as one of the top benefits of the account, although you should always consider your other options available before taking large amounts from your retirement savings prior to entering retirement as it could keep you from missing out on additional long-term growth.

There are a few catches when you decide to withdrawal any of the earnings. The rules are dependent on your age, length of time the account has been open, and what the withdrawal of earnings is for.

There is a 5-year rule for Roth IRAs. It refers to the time that has passed since the first contribution was made to any of the participant’s Roth IRAs.

If you are 59 ½ or older and have had the Roth IRA open for 5 years or more you can withdrawal your contributions and earnings without having to pay any tax or penalties, which is the biggest benefit of these accounts.

If you’ve reached the age of 59 ½ but have yet to hold the account for 5 years then your withdrawal of earnings will be subject to income tax, although the return of your contributions will remain tax free.

If you are under the age of 59 ½ and have held the account less that 5 years then you may be subject to income tax and a 10% penalty on the earnings. You could escape the penalty, but not the taxes if your withdrawal is for any of the following reasons:

– Unreimbursed medical expenses in excess of 10% of your adjusted gross income

– Medical insurance while unemployed

– Certain higher education expenses for you, your spouse, children or grandchildren

– To pay an IRS levy

– Active duty call up for reservists

– You decide to take Substantially Equal Periodic Payments

– First-time home purchase up to $10,000

-The owner’s disability

-To the account beneficiary in event of the account holder’s death

If you are under the age of 59 ½ and held the account for five years or more some distributions could be considered “qualified” meaning you would be exempt from taxes and penalties* on particular withdrawals. Qualified withdrawals are those made for a first-time home purchase up to $10,000, after the owner’s disability, or to the account beneficiary in event of the account holder’s death.

It’s important to note that Roth withdrawal are made on a first in, first out (FICO) basis. This treats any withdrawals as being made first from contributions and no earnings are considered taken out until all the contributions have been withdrawn.

Are there any other perks?

With Roth IRAs you have extra time to contribute. You have until the tax deadline to contribute for the previous calendar year. This is especially helpful if you are unsure what your final AGI will look like in a given tax year or prefer to make lump sum contributions.

They also provide better terms for your heirs. Heirs can receive the accounts balance tax free making them a great item to bequest.

Roth IRAs have no required minimum distributions like other pretax accounts like IRAs and 401ks. Since you aren’t required to take a minimum amount out each year at age 72 letting the account balance continue to grow tax free.

Are there any disadvantages?

The drawback unique to Roth IRAs is having to meet the 5 year rule even if you’ve reached the age 59 ½ to have your withdrawal (specifically the account’s earnings) completely tax free. However, this is still a better tax treatment than Traditional IRAs and other retirement accounts where you’ll always pay tax on the earnings.

There are many benefits exclusive to Roth IRAs. Understanding what they are and how they work is the first step in maximizing them for your situation. Talk to a financial advisor to help you determine if a Roth IRA is a good retirement tool for you.