Advantages of Roth IRAs
Investment income and growth held inside a Roth IRA aren’t taxed as they’re earned. This arrangement is similar to those of other retirement savings plans. You don’t have to report interest or dividends on your tax return before you retire and begin taking withdrawals. As with some other types of plans, there are penalties for taking money out early in some cases, however. You don’t get a tax deduction for contributions you make into a Roth IRA at the time you make them 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 in most cases, either. The savings held inside a Roth IRA are tied up until you reach age 59½, as is 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Funds withdrawn from a Roth IRA will be completely tax free, provided that: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, orThe distribution is paid to a beneficiary after your death, orYou 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. Any earnings withdrawn would become taxable.
Tax Treatment of Non-Qualifying Distributions
Withdrawals from Roth IRA accounts that don’t meet the criteria for qualified distributions are partially taxable. Your original contributions to the Roth IRA are returned to you tax free, but any earnings and growth will be fully taxable.
How Much Can You Contribute?
The maximum amount you can contribute to a Roth IRA in 2022 is $6,000 ($6,500 in 2023). Those who are age 50 or older can contribute an additional $1,000 per year as a catch-up contribution. Unlike with a traditional IRA, you can continue to contribute to a Roth IRA after age 70½ or age 72. Your exact age for being able to contribute to a traditional IRA depends on your year of birth. The limits apply collectively to both Roth and traditional 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 ($6,500 and $7,500 respectively in 2023.)
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 limit or up to your earned income for the year, whichever is less. For IRA purposes, earned income consists of wages reported on a W-2, self-employment income from a business or farm, and alimony. You can only contribute $5,000 to a Roth IRA, even though the limit is $6,000, if your income from all of these sources is just $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. It determines how much, if any, of that income can be contributed to a Roth IRA. 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 separately and apart from each other throughout the entire tax year. Most taxpayers will find that their MAGIs are their adjusted gross incomes (AGI) plus any tax-exempt interest income they claimed and any above-the-line deductions they took to arrive at their AGIs. These must be added back in.
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 within 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, and then later convert that traditional IRA to a Roth.
