The Basics of the Roth IRA
Mack Bekeza, CFP®
As a Certified Financial Planner™, one of the most frequent questions I am asked is, “How does a Roth IRA work?” The Roth IRA can be a powerful tool for retirement planning and is usually one of the first retirement accounts investors establish to save for retirement due to how easy it is for one to establish. However, just like with any other significant financial planning decision or strategy, it is essential to understand the ins and outs of the vehicle you choose to reach your goals. But before I get into the nitty-gritty of Roth IRAs, What exactly is a Roth IRA?
What is a Roth IRA?
The Roth IRA, introduced under the Taxpayer Relief Act of 1997, is a special Individual Retirement Account that allows Americans to contribute after-tax dollars in exchange for Tax-Free income in retirement, as opposed to the Traditional IRA where you are subject to taxation of your withdrawals.
Sounds pretty awesome, right? But can anyone open and contribute to a Roth IRA?
Who can use a Roth IRA
Anyone can establish and contribute to a Roth IRA as long as they meet two requirements:
- They must have “Earned Income” for the year they contribute to a Roth IRA
- Their income must not exceed the income and contribution thresholds established by the IRS for the year they contribute
Earned Income? Isn’t any income considered “earned?” Well… the IRS has a different opinion.
What is considered “Earned Income”
In short, the IRS considers you have “earned income” when you:
- Work for someone who pays you
- You own a business or a farm and paid from said business or farm
However, they have a page dedicated to “earned income” and can found by clicking here.
2019 and 2020 Contribution Limits and Income Thresholds
| Tax Filing Status | 2019 MAGI | 2020 MAGI | Maximum Annual Contribution Limit |
|
Single, Head of Household, Married Filing Separately (did not live together at any point of the year)
|
Less than $122,000 | Less than $124,000 | $6,000 ($7,000 if over age 50) |
| $122,000-137,000 | $124,000- $139,000 | Contribution Amount begins to lower | |
| $137,000 or more | $139,000 or more | Cannot Contribute | |
|
Married Filing Jointly or Qualified Widow(er)
|
Less than $193,000 | Less than $196,000 | $6,000 ($7,000 if over age 50) |
| $193,000-$203,000 | $196,000-$206,000 | Contribution Amount begins to lower | |
| $203,000 or more | $206,000 or more | Cannot Contribute | |
|
Married filing Separately (lived together at any time of the year)
|
Less than $10,000 | Less than $10,000 | Contribution is Reduced |
| $10,000 or more | $10,000 or more | Cannot Contribute |
After looking at this table, you might be asking yourself a few questions:
What on earth is MAGI?
Your Modified Adjusted Gross Income (MAGI) is essentially your Adjusted Gross Income (AGI) with certain deductions and tax-exempt income added back. For those who are wondering what your AGI is, that is essentially your gross income minus “above the line” deductions such as student loan interest, alimony payments, etc.
Your MAGI is an important number to know because it determines your eligibility for things such as IRA contributions, Medicaid, and subsidized health insurance plans.
Why is it when I reach a certain income threshold, and my maximum contribution amount begins to lower, why isn’t that a flat number or range on the table?
As fun as it will be for me to attempt to put that on the table without it making it look like something from Outerspace, it entirely depends on your individual or joint income situation. The IRS has provided guidance on this, click here to learn more.
If my earned income was less than the annual maximum contribution amount, can I still contribute up to $6,000-$7,000 for 2019 and or 2020?
In short, no! If you meet the income thresholds to contribute the maximum annual amount to a Roth IRA, your maximum annual Roth IRA contribution is either between $6,000-$7,000 or your total earned income, whichever is less.
So essentially, the mass majority of working Americans can contribute to a Roth IRA. But if you are someone who recognizes how great the Time Value of Money can be, there might be something you are wondering about…
Can I establish a Roth IRA for my minor child?
Does your minor child have earned income and meets the thresholds above? If the answer is yes, you can establish a Minor Roth IRA for your child! And as with any account owned by a minor, you will be able to serve as the “custodian” for the account, meaning that you will have full control of the account until the child has reached 18-21 years of age, depending on your state of residence.
Where can you open a Roth IRA
Roth IRAs can be opened at most financial institutions, including:
- Banks
- Credit Unions
- Brokerage Firms such as Charles Schwab, Vanguard, Fidelity, etc.
- Robo Advisors such as Betterment, WealthFront, etc.
- Any other “Qualified Custodian”
How can you contribute to a Roth IRA
Below are the most common methods for Roth IRA Contributions:
- Regular Contributions (i.e. ACH transfer from your bank account, depositing a check, bank wires, etc.
- Spousal Contributions: If you do not have earned income, but your spouse does, you can still make contributions to a Roth IRA. Another great thing about this is that if your spouse has at least $12,000-14,000 of earned income (depending on if only one or both of you are ages 50 or over), both yours and your spouses IRAs can be fully funded!
- Rollover Contributions: If you have a Roth 401(k) and are no longer working for that employer, you can rollover a Roth 401(k) to a Roth IRA. Please speak with your Financial Planner before doing this, this does not always make sense to do this.
- Roth Conversion: If you have a Traditional IRA or 401(k), you can perform what is called a Roth Conversion. Please consult with both your Financial Planner and CPA before doing this! With 2020 tax laws, you can no longer reverse these!!
*One thing to note is that you can only contribute cash and cannot contribute securities*
What can you invest in using a Roth IRA
With a Roth IRA, you can invest in the following:
- Individual Stocks
- Individuals Bonds
- Mutual Funds
- Exchanged Traded Funds (ETFs)
- Certificates of Deposits
- Covered Call Options
- Real Estate (a very limited amount of institutions and qualified custodians allow this)
Primary Benefits of a Roth IRA
- Tax-Deferred Growth
You will not pay taxes on capital gains or income while funds are held in a Roth IRA, this has a potent effect on how your account grows over time.
- Tax-Free Withdrawals after 59 ½
As long as you have held the Roth IRA for 5 years and have reached the age of 59 ½, your distributions will be tax-free!!
- No Required Minimum Distributions
Unlike a Traditional IRA, you do not have to take withdrawals on a Roth IRA when you reach 72 years old.
- No Age Restrictions on Contributions
As long as you have earned income and met the income thresholds, you can contribute to a Roth IRA at any age.
- Eligibility for a Tax Credit for low-income earners
If you meet certain income thresholds based on your filing status, you may be eligible for something called the “Retirement Savings Contribution Credit”. Even though you are contributing after-tax dollars, Uncle Sam will still hook you up with up a tax credit!
The Roth is a phenomenal investment vehicle, but there are a few caveats with this.
Primary Caveats of a Roth IRA
- Non-Deductable Contributions
Unlike Traditional IRA contributions, you will not receive a tax deduction for making contributions.
- Annual Contribution Limits are smaller than other retirement accounts
When compared to 401(k)s, Simple IRA, SEP IRAs, etc, the maximum annual contribution amount for 2019 and 2020 is between $6,000-$7,000 per individual.
- Contributions are Subject to Income Thresholds
If you make too much money, you may not be able to contribute to a Roth IRA at all, although some strategies avoid this caveat.
- Roth IRA Earnings are subject to Early Withdrawal Penalties
If you make an unqualified distribution, the earnings on your Roth IRA will be subject to income taxes and you will be slapped with a 10% early withdrawal penalty, The CARES act has provided relief for unqualified distributions for the 2020 tax year.
Another question I am asked is how exactly do Roth IRA early withdrawals work?
How do Roth IRA withdrawals works
This is something that can be explained better visually rather than jotting down the rules bit by bit. Fortunately, Investopedia has provided a table on early Roth IRA withdrawals. But before you check it out below, I want to explain two critical things about Roth IRAs and withdrawals.
Roth IRA contributions are not subject to Taxation or Penalties
Since you are contributing after-tax dollars, the IRS allows investors to take out contributions. Because contributions can take on many forms and are made at different times of your life, the IRS has established a unique order of how distributions are taken for income tax purposes. Before making any early withdrawals, consult with your Financial Planner and CPA to find out where exactly you land on the order below. The order will start from left to right.
Roth IRA Regular, Spousal, Rollover Contributions > Roth IRA taxable conversions > Roth IRA non-taxable conversions > Roth IRA Earnings (you are possibly subject to the most penalties when you reach earnings)
The 5 Year-Rule
In order to be completely eligible to take tax-free withdrawals from a Roth IRA, you must have owned the IRA for at least five years. This won’t be a big deal for anyone who established a Roth before 54 ½ but if you started a Roth after 54 ½, you must maintain it for five years in order to take tax-free withdrawals. So some people may need to wait until they are up to 64 ½ years old to take tax-free withdrawals. Ok now to the visuals on Roth IRA Earnings Withdrawal Rules.
| ROTH IRA WITHDRAWAL RULES | |||
| YOUR AGE | 5-YEAR RULE MET | TAXES AND PENALTIES ON WITHDRAWALS | QUALIFIED EXCEPTIONS |
| 59 ½ or older | Yes | Tax-free and penalty-free | n/a |
| 59 ½ or older | No | Tax on earnings but no penalty | n/a |
| Younger than 59 ½ | Yes | Tax and 10% penalty on earnings. You may be able to avoid both if you have a qualified exception |
* First-time home purchase
* Due to a disability * Made to a beneficiary or your estate after your death |
| Younger than 59 ½ | No | Tax and 10% penalty on earnings. You may be able to avoid the penalty but not the tax if you have a qualified exception |
*First-time home purchase
*Qualified education expenses *Unreimbursed medical bills *Health insurance premiums while you’re unemployed *Due to a disability *Made to a beneficiary or your estate after your death *Substantially equal payments *Due to an IRS levy |
Has the CARES Act Provided relief for people who need to make early Roth IRA withdrawals or retirement plans in general
Yes! For the 2020 Tax year, if you meet the qualifications stated by the CARES act, you may take distributions of up to $100,000 from an IRA or Employer Retirement Plan. These distributions will not be subject to the typical 10% early withdrawal penalty and income taxes can be spread over 3 years! People will also be able to re-contribute these distributions over the three year period as well. One thing to note that the $100,000 limit represents the aggregate of all retirement accounts.
Before you take on any investment or retirement strategy, it is vital that you seek out proper investment and tax advice beforehand. Investment performance is never guaranteed and investments may lose some or all of their value. On top of that, there may be severe tax consequences if withdrawals are taken improperly and can have a significant impact on your portfolio and retirement. Although we provide Investment Advice and Personal Financial Planning Services, we at MWM do not provide tax advice and any tax advice should be rendered by a licensed tax professional such as a CPA.
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