Roth IRAs (individual retirement accounts) can be a great way to invest for retirement. Similar to traditional IRAs, Roth IRAs lets your investment grow tax-free. With Roth IRAs, you can also withdraw any of your contributions without paying tax on it, but you cannot withdraw your earnings this way, barring specific conditions.
Like all retirement plans and investment accounts, there are rules regarding how you can withdraw your earnings, income limits, and contribution limits.
Related: unBanked Banking Resources
What Are Roth IRAs?
Roth IRAs are individual retirement accounts that let the owner withdraw their money tax-free as long as certain conditions are met. The most significant difference between these accounts and traditional IRAs is how they get taxed. The funds from Roth IRAs come from after-tax dollars and are not tax-deductible. But, when you withdraw funds, they are tax-free. Traditional IRAs work the exact opposite of this.
Understanding Roth IRAs
Roth IRAs are less restrictive than many other retirement accounts. Unlike 401ks and traditional IRAs, there is no required minimum distribution. Account holders can maintain their Roth IRAs indefinitely, and there are no age restrictions to contribute as long as the owner has earned income. You can fund Roth IRAs from sources like:
- Spousal contributions
- Rollover contributions
- Regular contributions
Any regular contributions to a Roth IRA have to get made in cash—you cannot use assets or securities. However, the money in a Roth IRA has a variety of investment options, like ETFs, CDs, stocks, etc.
Roth IRAs & Insurance
It’s important to know that if your Roth IRA is with a banking institution, it will fall under a different insurance category—Roth IRA insurance coverage is not as robust as conventional deposit accounts. The FDIC still insures the accounts up to $250,000, but that is a combination of your banking accounts, not for each one.
For example, if you have CDs and a Roth IRA with a combined value of $350,000, you’ll have $100,000 in vulnerable assets that aren’t covered by the FDIC.
Traditional IRAs vs. Roth IRAs
There are three main things that factor in when choosing between a traditional IRA and a Roth IRA:
- Your tax bracket
- Your expected rate at retirement
- Personal preference
People who expect to land in a higher tax bracket after retirement typically benefit more from Roth IRAs—the taxes you pay now will likely be less than you would pay in the future. Lower-income workers and younger investors usually benefit the most from Roth IRAs because of this and the snowballing effect.
Traditional IRA holders not only have to pay taxes when withdrawing their funds, but in the event of a death, the beneficiary still must pay taxes on the distribution of money—funds in a Roth IRA are after-tax, so that problem is non-existent.
Roth 401ks and other employer-sponsored Roth accounts can roll over into a Roth IRA in the future without any tax consequences.
However, contributions to a traditional IRA come with tax deductions and benefits that you don’t get immediately with a Roth IRA.
Eligibility for a Roth IRA
The biggest requirement for Roth IRA eligibility is having earned income. There are two types of eligible income: by running your own farm or business or working for a person or company that pays you salary, commission, types, or other taxable earnings.
Earnings from investments, properties, or any other assets do not count as earned income for a Roth IRA. Income that doesn’t count for a Roth IRA includes:
- Nontaxable alimony
- Social Security benefits
- Unemployment benefits
- Child support
- Wages earned by inmates
Other than the type of income restrictions, there aren’t many other eligibility requirements. Like a traditional IRA, there is no age limit for who can contribute to the account. You can contribute to a Roth investment account at the same time as an employer-sponsored 401k.
Spousal Roth IRAs
Using spousal IRAs is a way for couples to boost their contributions when one partner earns significantly more than the other one. Married partners can make Roth IRA contributions on their spouse’s behalf. These accounts are subject to the same limits and regulations as regular contributions, and the accounts cannot be joint accounts. These are the eligibility requirements for spousal Roth IRA contributions:
- The account holder and contributor must be married and file jointly on tax returns.
- The person making the contribution has to have eligible compensation.
- The combined contribution for both partners cannot exceed the compensation reported on a joint tax return.
- The contributions to a single Roth IRA cannot pass the contribution limits, but the spouse can hit the limit on their own and their partner’s account.
Income Limits for Roth IRAs
Roth IRA eligibility also depends on a person’s overall income earnings. Income limits on Roth IRAs restrict high earners from contributing large amounts—these limits go off of modified adjusted gross income (MAGI) and the contributor’s tax-filing status. MAGI takes the AGI from your tax return and adds your deductions back in (like interest on student loans and self-employment taxes).
If your MAGI is below a specific level, you can contribute the full amount to a ROTH IRA, which is $6,000 for most people and $7,000 for people aged 50 and up. If your MAGI is over the limit, you can’t contribute at all, and if it’s in the “phase-out” range, you can make smaller contributions but not the full amount. These are the income limits for 2021:
- Married filing jointly:
- Full contribution: Less than $198,000
- Phase-out range: $198,000 – $207,999
- Ineligible: $208,000 and higher
- Married filing separately (and living together):
- Full contribution: N/A
- Phase-out range: Less than $10,000
- Ineligible: $10,000 and higher
- Head of household, single, or married filing separately (and not living together):
- Full contribution: Less than $125,000
- Phase-out range: $125,000 – $139,999
- Ineligible: $140,000 and higher
Related: unBanked Investing Resources
Roth IRA Contribution Limits
While people of any age can make Roth IRA contributions, the annual contributions to the account cannot exceed the amount of income earned in that year. For example, anyone under 50 that earns income in the full contribution range listed above can contribute $6,000 to their Roth IRA annually.
Couples that have highly disparate incomes often ask if they can use the higher-earning spouse’s name for their Roth IRA, but as the name implies (individual retirement account), that goes against IRS regulations.
However, a spouse can make contributions to their partner’s Roth IRA. For example, if one spouse earns $100,000 and the other only earns $10,000, the higher earning spouse can contribute $6,000 to their own account and an additional $6,000 to their partner’s Roth IRA.
Contributions & Timing
While you can own and make contributions to both a Roth IRA and a traditional IRA, the limit applies collectively to each one. That means if you contribute $3,000 to one IRA in 2021, you could only deposit $3,000 into another IRA during the same year. You can make contributions up until the tax filing deadline of the following year. Getting approved for a tax deadline extension does not give you additional time to make IRA contributions.
If someone files and receives a tax refund early, they can use that money to add to their Roth IRA as long as it’s before the deadline to file. Also, if you were to convert your money from a Roth IRA to another retirement account, that would not impact the annual contribution limit. Additionally, rollovers from one IRA to another do not affect the contribution limit.
Roth IRA Tax Breaks
It’s important to understand that Roth IRA contributions are not deductible for the year you contribute—they are to build savings, not to get a current tax deduction. Roth IRA contributions consist of after-tax money, which is why you can withdraw your contributions without paying taxes on them.
However, eligible persons can get a tax credit for their Roth IRA contributions—this could be anywhere from 10-50%. This tax break is called the “Saver’s Credit,” and it can be up to $,1000 for eligible contributors. Here’s who qualifies for the Saver’s Credit:
- Taxpayers with incomes below $66,000 and are married, filing jointly.
- Head of household filers whose income is under $46,500.
- Single taxpayers with incomes below $33,000.
Opening a Roth IRA
To open a Roth IRA, you must go through an established institution that is approved by the IRS to offer those accounts. That usually means banks, credit unions, brokerage companies, and savings and loan firms. You can establish a Roth IRA at any time, but contributions have to get made before the IRS tax-filing deadline to count for that year, and tax extensions do not apply.
When opening a Roth IRA, you’ll receive two important documents that explain all of the rules and regulations that apply to the account and create a formal agreement: an IRA disclosure statement and an IRA adoption agreement and plan.
When choosing a financial institution to open your Roth IRA with, it’s important to consider what types of investment options they offer and what their fee structure looks like, as those two factors can significantly impact your returns from the account.
Two other aspects to consider are your investment preferences and risk tolerance. Active investors who plan on making a lot of trades should look for providers that offer lower trading costs, which isn’t as important for more passive investors. Some providers might charge fees for inactivity if you don’t do anything with your investments for too long. Certain providers might have an extremely diverse offering of stocks and mutual funds, while others might only have specific options to offer—the institution you choose depends highly on personal preferences.
You’ll also want to pay attention to specific requirements that each institution has regarding their Roth IRAs. Existing customers may be able to get discounts on their Roth IRA fees, or if you use the same institution for banking, you might get some additional banking products along with the IRA.
Withdrawing From a Roth IRA
Unlike regular IRAs, there’s not a required minimum distribution for Roth IRAs—you can withdraw your contributions at any time without penalties. But, withdrawing your earnings works differently.
To take out your earnings without any fees, you must be 59 ½ years or older, and you must have owned the Roth IRA account for at least five years (known as the 5-year rule). Otherwise, you will pay up to 10% in penalties plus taxes on your earning. Here’s how it works:
For people who meet the 5-year rule:
- Under 59 ½: You’ll pay taxes and penalties on your earnings. However, if you have a permanent disability or are using the money to buy a house for the first time, you may be able to avoid them.
- Over 59 ½: You won’t owe taxes or penalties.
For those who don’t need the 5-year rule:
- Under 59 ½: Similar to people who meet the 5-year rule, but you may be able to avoid only the penalties, not the taxes.
- Over 59 ½: You’ll pay taxes on your earnings, but no penalty fees.
However, there are exceptions to this:
- Medical expenses: If you withdraw earnings from a Roth IRA to pay unreimbursed medical expenses that are more than 10% of your AGI for the distribution year, you won’t have to pay penalties or taxes on the funds.
- Medical insurance: You won’t be liable for penalty fees if you use the earnings to pay for medical insurance after losing a job.
- Higher-education expenses: Any expenses related to higher education, like tuition and supply costs, are not subject to taxes and penalties as long as you use the funds in the same year that you withdraw them.
- Childbirth & adoption expenses: You don’t have to pay the penalties and taxes on your withdrawn earnings (up to $5,000) if they get used for these expenses within one year of the withdrawal.