IRA stands for Individual Retirement Account. A new kind was started in January of 1998, and it delivered a wonderful benefit that previous retirement plans didn’t have. That benefit is having accumulation and withdrawal both be tax-free. This was named the Roth IRA, and it was included with 1997’s Taxpayer Relief Act and 1998’s IRS Restructuring and Reform Act.
Investors are able to establish and then add to their Roth IRA two different ways:
- Contributions: These represent what is considered “new” money
- Conversions: These are transfers from previous conventional IRAs.
Roth IRAs can be funded using after-tax dollars via conversions or contributions. There isn’t any front-end deduction coming out of an investor’s gross income.
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Roth IRAs in 2017 permit annual nondeductible contributions as high as $5,500 for singles out of their earned income and $11,000 for jointly filing married couples split at $5,500 per spouse. Also, investors over the age of 50 can make contributions as high as $6,500.
If you’re not sure what earned income is, it can be either alimony or work-related compensation, be it as an employee or self-employment.
You should also note that the limit for annual Roth IRA contributions goes down by any traditional IRA contributions for that year. See our related guide about the differences between a self-directed and a traditional IRA for more information.
If you want to make your decision and open a gold IRA account, refer to our best gold IRA company guide for more details.
Investors in higher income brackets face Roth IRA limitations. There is an eligibility limit for doing full contributions, and it’s subjected to the annual MAGI ceilings. MAGI stands for Modified Adjusted Gross Income.
The 2017 ceilings are $133,000 for those filing taxes as a single and $196,000 for couples who file jointly.
Contributions get pro-rated when income falls into the phase-out range of $118,000 to $133,000 for those filing as individuals or $186,000 to $196,000 for a married couple who is filing jointly. Roth IRA contributions aren’t permitted when income surpasses the phase-out range.
You should note that MAGI is simply Adjusted Gross Income (AGI) with these add backs:
- Deductions for traditional IRA contributions
- Student loan interest
- Qualified tuition or associated expenses
- Passive activity losses
- Exclusions claimed off of Series EE interest given qualified higher education costs that have been paid
- Adoption expenses paid by an employer
- Foreign earned income
- Foreign hosuing costs
Also, any conventional IRA conversions into a Roth (see below) aren’t considered contributions. As such, they aren’t included in MAGI calculations or the annual contributions while determining eligibility for a Roth.
From 2011 onward, investors could convert traditional IRA funds into a Roth no matter their individual income. Every Roth conversion gets treated as a distribution and is subjected to ordinary rates of tax income.
Given that, do so with caution. You need to consider the potential tax consequences and your time horizon for your Roth IRA. Any taxes resulting from conversions are accountable to the conversion year.
A significant portion, and possibly all, of a conversion is probably going to be subjected to taxation happening at ordinary rates of income, based on the specific proportion of:
- accumulated earnings
- deductible contributions
- nondeductible contributions
in the cumulative conversion amount.
Just keep in mind that nondeductible contributions won’t be subjected to taxation. Also, you need to factor the aggregate balance of your cumulative IRAs in your ownership in order to ascertain taxable income happening from the conversion.
For instance, if you have two IRAs, one deductible and one not, then you have to consider proportionate percentages from both of the IRAs covering accumulated earnings and contributions both deductible and nondeductible for tax purposes.
This holds true even when you transfer only funds from your nondeductible IRA.
Reversing a Roth conversion is permissible. In short, you can cancel your conversion so you revert back to a conventional IRA. Having said that, you only get a single conversion reversal each tax year, so you need to choose these carefully.
Take note of the fact that high-income earners need to consider the potential consequences of their future tax rates when making decisions about Roth conversions.
For instance, Affordable Care Act legislation that became official law in 2010 imposed a Medicare surtax of 3.8% starting in 2013 on income in excess of $200,000 for single filers and $250,000 for those filing jointly. This surtax is assessed on the lesser of:
- Net Investment Income
- MAGI exceeding relevant income thresholds for filers both joint and single
Net investment income in terms of calculating the contribution Medicare tax for unearned income covers the following things:
- Capital gains
- Passive business pass-through income
The following kinds of income aren’t subjected to the additional Medicare tax:
- Municipal bond interest that is tax-exempt
- Capital gains taxes that are excluded from principal residence sales
- Non-taxable veteran’s benefits
- Distributions from conventional IRAs, Roth IRAs, profit-sharing plans, 457 plans, 401(k) plans, and 403(b) plans
Case A: A person filing as a single or a couple who files jointly surpasses the MAGI thresholds with a net investment income of zero. There is no Medicare surtax due since 3.8% of a zero net income is still zero.
Case B: A person filing as a single or a couple who files jointly lands under the MAGI thresholds. If their net investment income is $100,000, there is no Medicare surtax, given how excess MAGI thresholds didn’t happen.
Case C: A person filing as a single or a couple who files jointly surpasses the MAGI thresholds by a total of $40,000, and $50,000 of it is their net investment income. The Medicare surtax of 3.8% is $1,520 applied to the $40,000 in excess MAGI, given how it’s lesser than the net investment income of $50,000.
Case D: A person filing as a single or a couple who files jointly surpasses the MAGI thresholds by a total of $40,000, and $30,000 of that is their net investment income. The Medicare surtax of 3.8% is $1,140 applied to their $30,000 amount of net investment income since it’s the lesser of the excess MAGI of $40,000.
One thing that seriously distinguishes a Roth IRA from conventional and traditional IRAs is how withdrawals are given special treatment.
Since Roth IRA contributions are nondeductible, the withdrawals of those contributions can happen free of taxes and penalties. In short, you can do them pretty much anytime without restrictions.
You can withdraw your accumulated earnings totally tax-exempt provided you hold your Roth IRA for at least five years and any of these qualified exemptions applies:
- Hit the 59 1/2 minimum age
- Get as much as $10,000 to acquire your first-time home
Any withdrawals of amounts that could be attributed to conversions have seen clarifications due to technical corrections.
The original statute left a huge loophole that permitted investors to convert a conventional IRA into a Roth, make a declaration that the taxable income was from 1998 conversion over the span of four years, but then withdraw that conversion immediately with no additional tax ramifications.
Technical corrections have closed that loophole because there is now a waiting period of five tax years imposed for investors younger than 59 1/2, starting with the first conversion year.
Technical corrections have also been imposed on the distribution or ordering rules. Now, withdrawals are deemed to have come from contributions first.
This is then followed by a process of first in, first out for all conversion amounts subjected to taxes, followed by conversion amounts not subjected to taxes upon conversion, with accumulated earnings coming in last.
Such ordering rules also negated the requirement for distinct Roth IRA accounts for conversions and contributions.
Additionally, separate from other kinds of IRAs, a Roth doesn’t have a requirement for minimum distribution. If you want, you can keep your Roth IRA for an indefinite amount of time and not make withdrawals.
Penalties and Taxes
As stated earlier, contribution withdrawals are free of taxes and penalties at any time. You can also withdraw conversion amounts free of taxes and penalties, assuming you’ve held the conversion sums for at least five years or are 59 1/2 years of age.
On the other hand, if you withdraw from your conversion amounts prior to either of these restrictions, you will have an early withdrawal penalty of a 10% tax assessed on the conversion amounts for that particular year.
Once all your cumulative conversion amounts and contributions have been withdrawn, any subsequent withdrawals come out of your accumulated earnings.
Should you not meet any of the qualified exemptions listed earlier, then any early withdrawals from your accumulated earnings will be taxed at ordinary rates of income plus face the early withdrawal penalty of 10% taxation.
The tax penalty of 10% imposed on early withdrawals for both accumulated earnings and conversions gets waived if the following circumstances occur:
- Equivalent and routine withdrawal payments over the expected life expectancy of the owner
- Health insurance premiums for someone unemployed
- First-ever home purchase
- Qualified expenses for higher education
- Medical expenses surpassing 7.5% of AGI
Inherited Roth IRAs
As is the case in conventional IRAs, Roth IRA distributions are different based on whether or not the transfer is directed towards spousal or non-spousal beneficiaries. Typically speaking, spouse beneficiaries have more flexibility than non-spouse beneficiaries.
A spouse beneficiary can choose to handle an inherited Roth IRA as their own via spousal rollover. If so, they would have:
- The same rules applying to distributions as applied to the original owner
- The power to make more eligible conversions and contributions
- No mandated requirements for distribution
When a spouse doesn’t elect to do a rollover, then the minimum distribution rules covering conventional IRAs will apply.
Non-spouse beneficiaries can’t combine with pre-existing Roth IRAs or do conversions or contributions with the Roth IRA they inherit. Non-spouse distributions have to follow either one of these two rules:
- They must take the whole distribution by December 31st in the fifth year following the original owner’s year of death.
- Or they must choose to receive their distributions over their remaining span of life expectancy.
Accumulated earnings withdrawals that happen within five years of an original Roth are subjected to ordinary rates of income tax. On the other hand, the tax penalty of 10% for early withdrawals gets waived.
Effective Strategies to Consider
A Roth IRA isn’t supposed to replace your 401(k) plan, particularly if you have an employer who matches a percentage of your contributions to your 401(k).
In ideal circumstances, you would maximize your 401(k) before prioritizing a Roth IRA as the next investment vehicle in line since your earnings will grow free of taxes and you can make withdrawals without taxes.
This is a potent combination if you can qualify and then meet the minimum five-year holding requirement plus meet any of the specifically qualified withdrawal conditions.
A lot of investors face the choice of a Roth IRA versus a deductible IRA or nondeductible IRA. Roth IRAs are clear winners over nondeductible IRAs. While both are quite similar, one difference separates them a lot.
A Roth IRA has tax-free earnings withdrawals while non-deductible IRAs are taxed at ordinary rates of income.
Choosing between a Roth IRA or a deductible IRA gets more complex. A Roth IRA is nondeductible and has tax-free accumulations, whereas a deductible IRA has taxable withdrawals and tax savings on the front end.
Typically, the higher your tax rate is at withdrawal, you should go with the Roth. If your tax rate might be lower, then a deductible IRA might be a better choice.
Always consider your tax rates, both current and future. Analysts are mixed about the Roth versus a deductible IRA, but if your time horizon is long-term, then the Roth might work better given the tax-free accumulation earnings instead of tax-deferred.
Another choice that investors sometimes need to make is whether or not they convert a traditional IRA over to a Roth. Time horizon and tax consequences are the two biggest factors you need to think about in terms of a Roth conversion.
The crucial thing here is to compare any current taxes stemming from a conversion with any future accumulated earnings the Roth IRA might give you with no taxes on them. As a general rule of thumb, if you are getting close to retirement, then you shouldn’t convert over to a Roth.
On the other hand, if your time horizon is long-term, and your conventional IRA taxes aren’t going to constrain your finances, then a Roth IRA conversion might prove helpful.
Conclusion about the Roth IRA
Your key takeaway here should be that Roth IRAs support many goals, including acquiring a first home, adding to your estate, or just supplementing your retirement, go to our general investment advice and strategies for more information.
A Roth IRA lets you enjoy accumulations and tax exempt withdrawals that just weren’t available in previously qualified plans.