Putting away any money for retirement puts you ahead of one-quarter of Americans who have no retirement savings at all, according to a report from the Federal Reserve. Depending on your timeline, income level, and anticipated tax rate in the future, a Roth IRA can make a lot of sense. Let’s take a look at how these work.
Non-deductible contributions and tax-free withdrawals
In contrast to a traditional IRA, where contributions are tax deductible but withdrawals are taxable, contributions to a Roth IRA are not deductible, but eligible withdrawals are tax-free. To qualify as eligible, two conditions must be satisfied:
- Roth IRA owner is older than 59 1/2.
- Withdrawal is five years after first contribution to the account.
For Roth IRAs funded with annual contributions, the five-year rule is a once-in-a-lifetime rule. That means that even if you open additional Roth IRA accounts, once five years have elapsed since the first contribution to any Roth IRA account, the five-year rule is satisfied for all accounts funded with contributions. There’s a separate five-year rule for Roth IRAs converted from traditional IRAs or other retirement accounts, which we’ll discuss below.
The clock for the five-year rule starts ticking at the beginning of the tax year for which the contribution is designated. Since contributions can be made up to the due date of a tax return, including extensions, this can work to your advantage. For example, if you decide on Aug. 1, 2020, to open a Roth IRA for their extended 2019 tax return, the five-year clock starts on Jan. 1, 2019.
Contribution limits depend on income and filing status
For 2019, the maximum Roth IRA contribution is $6,000, or $7,000 for those age 50 and older. This limit applies to the total contributions made to either Roth or traditional IRAs. You can’t double up and contribute $6,000 to a Roth IRA on top of a $6,000 contribution to a traditional IRA.
However, unlike limits for traditional IRAs, the contribution limits are not impacted by the participation of either the taxpayer or spouse in a retirement plan at work. Allowable contributions depend only on income and filing status. As usual, there are phase-out limits for contributions. For 2019, the phase-out ranges are as follows:
- Married filing joint or qualified widower: $193,000 to $203,000.
- Married filing separate and lived with spouse: $0 to $10,000.
- Single, head of household, or married filing separate and not living with spouse: $122,000 to $137,000.
Below these limits, contributions are limited to earned income. That means that if your 16-year-old daughter earns $4,000 at her part-time job, you can make a $4,000 Roth IRA contribution on her behalf.
Benefits of Roth IRAs
The biggest benefit of a Roth IRA is that all eligible distributions are tax-free. This makes them most beneficial to people who anticipate paying taxes at a higher rate in the future.
In contrast to traditional IRAs and 401(k)s, distributions are not required when the owner reaches a certain age. In addition, contributions can be made after age 70 ½. Beneficiaries of inherited Roth IRAs can make tax-free withdrawals as long as the original owner satisfied the five-year rule. They may also have the option to stretch those distributions out over their lifetimes.
Conversions from other retirement accounts
You can also convert balances in other pre-tax retirement accounts, such as traditional IRAs or 401(k)s to Roth IRAs. The amount converted will be included in taxable income for the year of the conversion, so it may make sense to spread the conversion over several years.
However, a five-year rule applies to each conversion. That means that if the conversion is spread over two or more years, you will need to wait five years after the last conversion to make tax-free withdrawals.
Because of the hefty upfront tax bite, conversions don’t always make sense. If you have a long enough time horizon to recoup the conversion tax payment through growth in the converted amount, this can be a good deal. But, some states don’t tax retirement distributions, so a Roth conversion may not reduce future taxes enough to make it worthwhile.
More details about Roth IRA contributions or distributions can be found in IRS Publications 590-A, Contributions to Individual Retirement Accounts (IRAs), and 590-B, Distributions from Individual Retirement Accounts (IRAs). Make sure you know about this option to save for retirement!