Table of Contents
- Roth IRA – One of the Best Retirement Tools
- Types of IRAs, and Why a Roth IRA Rules
- Roth IRA Eligibility Requirements
- 2021 Roth IRA Income Limits
- Roth IRA Contribution Limit Rules
- Roth IRA Distribution Rules
- Roth IRA Conversions
- Deductible and Non-Deductible Traditional IRAs
- Roth IRA Conversion Process
- Taking Advantage of Roth Conversions (Timing is Everything!)
- Who is Eligible for Roth IRA Conversions?
- Two Options Converting Traditional IRAs into Roth IRAs
- Once You Go Roth, You Never Go back
You’ve probably heard about a Roth IRA before; it’s one of those terms that gets bandied about on TV or the radio with great frequency. And with good reason – a Roth IRA is a retirement account that happens to be one of the best ways to prepare for retirement.
Roth IRAs are tax-advantaged retirement accounts that offer a wide variety of investment opportunities and exceptional tax benefits.
Individuals can make contributions with after-tax dollars into an investment account where the contributions will grow without the drag of taxes until they can be withdrawn tax-free in retirement at age 59½ or later. To put this another way, you can contribute to a Roth IRA with money that you have already paid taxes on, the money compounds tax-free in your account, and you can make tax-free withdrawals in retirement. This is a massive tax benefit!
To top it off, there are no Required Minimum Distributions (RMDs), meaning investors don’t have to take withdrawals if they don’t want to.
This gives investors several tremendous advantages when they reach retirement age. They can withdraw their investments without paying additional taxes, or they can defer their withdrawals until they are ready.
I’ll give you an introduction to Roth IRAs – what they are, why they are essential to good retirement planning, Roth IRA eligibility rules, Roth IRA contribution limits, distribution rules, Roth IRA conversion tips, and a few other tips about Roth IRAs.
Roth IRA – One of the Best Retirement Tools
Retirement planning is something everyone needs to do. Even if you serve in the military long enough to earn a military retirement and pension, it might not be enough for your golden years. It is essential for everyone to take retirement planning into their own hands, and retirement accounts such as the Thrift Savings Plan, 401k plans, and IRAs are a great way to do that.
Types of IRAs, and Why a Roth IRA Rules
There are two types of IRAs available to most people – Traditional IRAs and Roth IRAs. They are fairly similar but have one important distinction – when you pay taxes on your contributions and withdrawals.
Here is a quick primer about the differences between Traditional and Roth IRAs:
- Traditional IRA: Contributions are tax-free if you meet income requirements, and withdrawals are taxed in retirement years. There are Required Minimum Distributions (RMD) once you reach age 72.
- Roth IRA: Contributions are made from income that has already been taxed, withdrawals in retirement are tax-free. There is no RMD.
Let’s break this down in simple terms.
With a Traditional IRA, you can take a tax break on your income now, but you will have to pay taxes in the future when you withdraw your retirement funds. You will also have to begin taking withdrawals from your account once you reach the RMD age, whether or not you need the income.
With a Roth IRA, you make contributions from income that has already been taxed, making you eligible to receive tax-free withdrawals in your retirement years.
This is a great deal, especially if you are in a lower tax bracket now than you anticipate being in retirement. It also takes the guesswork out of retirement planning since you will know that the money you have in your account will not be subjected to taxes. Finally, you aren’t required to take distributions, so you can leave your money in your account and continue to let it grow (this can also be a great advantage when it comes to estate planning).
Roth IRA Eligibility Requirements
There are two main Roth IRA eligibility requirements to keep in mind:
- You must have earned income and
- You must meet income eligibility requirements (see next section).
The earned income must be taxable income and can include income such as wages and salaries, tips, bonuses, and other compensation directly related to a service you provided. Income from interest, dividends, or other investments does not qualify as earned income for Roth IRA purposes.
There is also a special provision for military members: the HERO Act. The Heroes Earned Retirement Opportunities (HERO) Act allows military members with tax-free combat pay to be able to contribute to Roth IRAs and other retirement plans.
2021 Roth IRA Income Limits
There is also a cap on how much you can earn and still be able to contribute to a Roth IRA. For the 2021 tax year, Roth IRA eligibility begins phasing out at an annual Modified Adjusted Gross Income (MAGI) of $125,000 for single tax filers. Single tax filers are no longer eligible to contribute to a Roth IRA when their income reaches $140,000. The limits are higher for married filing jointly. Eligibility begins phasing out at $198,000 and ends at $208,000.
The following table breaks down the full Roth IRA income limits:
|2021 Roth IRA Income Limits|
If Your Filing Status Is...
|And Your Modified AGI Is...||Then You Can Contribute...|
|Married Filing Jointly or Qualifying Widow(er)||$198,000 or less||up to the limit|
|more than $198,000 but less than $208,000||a reduced amount|
|$208,000 or more||Zero.|
|Married Filing Separately and You Lived with Your Spouse at Any Time During the Year||less than $10,000||a reduced amount|
|$10,000 or more||Zero.|
|Single, Head of Household, or Married Filing Separately and You Did Not Live with Your Spouse at Any Time During the Year||$125,000 or less||no deduction.|
|more than $125,000 but less than $140,000||a partial deduction.|
|$140,000 or more||Zero.|
What to Do if Your Income Exceeds Roth IRA Contribution Limits
The tax advantages for IRAs are incredible, so the government limits them to people who fall within certain income brackets. If you don’t meet the income requirements to get the tax benefits from the Traditional IRA, or contribute directly to a Roth IRA, you can still contribute to a non-deductible Traditional IRA, then convert it to Roth IRA at a later date. It’s kind of like a back door that enables just about anyone to contribute to a Roth IRA, regardless of their MAGI.
Roth IRA Contribution Limit Rules
The next thing to consider is how much you will be able to contribute to your Roth IRA. If you meet income requirements, then you will be able to contribute up to $6,000 if you are under age 50, or $7,000 if you are age 50 or older (the additional $1,000 represents a catch-up contribution to help those closer to retirement better reach their investment goals). Contribution limits for both Roth and Traditional IRAs are the same.
It is important to note that these limits apply across all IRAs opened during the specific tax year. Since you can open both a Traditional and Roth IRA in the same year, you should be careful not to exceed contribution limits across both accounts.
The following chart shows IRA contribution limits for 2002-2021.
|Tax Year||Contribution Limit |
Age 49 & Below
|Catch-up Contribution |
Limit Age 50 & Above
Age 50 & Above
|2019 - 2021||$6,000||$1,000||$7,000|
|2013 - 2018||$5,500||$1,000||$6,500|
|2008 - 2012||$5,000||$1,000||$6,000|
|2006 - 2007||$4,000||$1,000||$5,000|
|2002 - 2004||$3,000||$500||$3,500|
Roth IRA Distribution Rules
Distributions are one of the main benefits of using a Roth IRA compared to a Traditional IRA. As previously mentioned, distributions from Roth IRAs are tax free, whereas Traditional IRA distributions are taxable. Roth IRAs have an additional benefit over Traditional IRAs – there is no required minimum distribution age with a Roth IRA. But there are a few more rules and considerations you need to be aware of.
First, you can withdraw your contributions at any time, tax-free and penalty-free. But that does not apply to the earnings or interest on your contributions.
To avoid paying penalties on Roth IRA withdrawals on earnings or interest, you must meet two criteria: you need to wait at least five years from the date you contributed the funds, and you must be at least age 59½.
This is called the 5-year rule.
Exceptions for early Roth IRA withdrawals: There are a few other Roth IRA withdrawal rules which may apply to your situation. For example, you may be able to make penalty-free withdrawals if you become disabled, if you wish to purchase your first home, or to pay for qualified educational expenses. I recommend reading more about Roth IRA withdrawal rules or consulting with a financial planner or tax professional before making early Roth IRA withdrawals.
Early Roth IRA withdrawals that are not qualified under IRS rules may be subject to a 10% early withdrawal penalty. This is not something you want to pay it if can be avoided!
Roth IRA Conversions
Should you consider a Roth IRA Conversion?
Moving your money held in a Traditional IRA into a Roth IRA is called a “Roth IRA Conversion.” Many people choose to do a Roth IRA conversion because Roth IRAs have a tax advantage over Traditional IRAs in that the distributions are not taxable income. The lack of Required Minimum Distributions also gives Roth investors more long-term flexibility.
Deductible and Non-Deductible Traditional IRAs
There are two types of conversions: conversions from deductible Traditional IRAs and Non-Deductible Traditional IRAs.
Deductible IRAs are those in which you deducted the contribution on your taxes. Non-deductible IRAs are those that did not have a corresponding tax deduction. These are most common for people whose income exceeded the Traditional and Roth IRA income limits. Contributing to a non-deductible IRA still allows them to contribute to an IRA during the tax year. This is often used by people who want to do a Backdoor Roth IRA (contributing to a non-deductible IRA, then immediately converting it into a Roth IRA).
Roth IRA Conversion Process
During the conversion process, the money you roll over from a deductible Traditional IRA into a Roth IRA is added to your annual taxable income for that year. This is considered taxable income because you haven’t yet paid taxes on the contributions or their earnings. The government still needs to assess taxes on that income and the gains. So you pay when you convert and file your taxes the following year.
Non-deductible IRA conversions are not considered taxable income. So you won’t need to pay taxes on the amount of the contribution. However, you would need to pay taxes on any gains from the non-deductible IRA.
Many people who take advantage of Roth IRA conversions using non-deductible IRAs make sure to convert the non-deductible IRA as soon as possible to avoid any taxable gains within the account. This is often called a Backdoor Roth IRA.
Important note – the Pro-rata Rule. The IRS requires taxpayers who convert a Traditional IRA to a Roth IRA to convert them on a pro-rata basis, meaning, you can’t just convert only non-deductible IRAs to a Roth IRA if you also have deductible IRAs. You must convert them proportionally. This is done so the IRS will receive taxes at the time of conversion. This is an advanced topic, and one worth investigating with a tax professional or fee-only financial planner.
- Roth IRA Conversion Timing (Part One)
- How to Optimize Roth Conversions: Why Timing Is Important (Part Two)
- Roth Conversion for Your TSP Account – 5 Tax Planning Considerations
Taking Advantage of Roth Conversions (Timing is Everything!)
When you pay taxes on the money you roll over, you pay taxes on the current value of the money, making it possible to take advantage of economic downturns or your current tax bracket.
Future distributions from the newly created Roth IRA will be the same as any other Roth IRA, which is to say, they will be nontaxable. Investors who are currently in a low tax bracket often decide to invest using Roth IRAs because they may expect to be in a higher tax bracket when they retire. This can be common for those who have recently retired, or those who are in between jobs.
Paying taxes on the money in a lower tax bracket will save money over paying taxes later when you are in a higher tax bracket. Many people choose to convert a Traditional IRA into a Roth IRA when the economy is struggling because their Traditional IRA will have less value than in strong economic times and it results in a lower taxable amount.
Who is Eligible for Roth IRA Conversions?
You must meet a few eligibility requirements for converting a Traditional IRA into a Roth IRA, including:
- You cannot convert a Traditional IRA if you inherited it from someone other than a spouse.
- You can convert Traditional IRAs to Roth IRAs even if you have made a rollover within the same year.
- You can convert a portion of the Traditional IRA into a Roth IRA but not just the nontaxable part.
Two Options Converting Traditional IRAs into Roth IRAs
Note: There are two ways to move money from a Traditional IRA into a Roth IRA.
- You can convert the funds yourself by taking a distribution from the Traditional IRA and rolling it into a Roth IRA within 60 days; or
- You can contact the bank or broker who manages your Traditional IRA and instruct them to transfer the money into a Roth IRA for you.
Most investment firms are happy to initiate and process the Roth conversion or rollover for you. This is typically the easiest and safest method since you avoid any potential mistakes or penalties.
For example, if you cash out your IRA but do not roll the IRA funds into your new IRA within 60 days, it would be treated as a withdrawal, not a conversion. And you would owe taxes on the full amount, plus penalties if you are under age 59 ½.
Whether you choose to roll over the funds or do a transfer, it’s necessary that you use the entire Traditional IRA distribution amount to fund the Roth IRA to avoid early withdrawal penalties and fees. You can’t decide to keep some of the money out as pocket cash or to take a vacation, for example.
Once You Go Roth, You Never Go back
The prospect of having a tax free nest egg in retirement is very attractive, and something I don’t recommend you pass up. There aren’t many opportunities for tax-free income, especially when it comes to investments. And the longer you have before you reach retirement age, the more time you have for compound interest to increase your nest egg. If you are eligible, I highly recommend opening a Roth IRA and maxing out your contributions each year.
Take action! If you are interested in opening a Roth IRA, then check out this list of recommended places.