IRAs, 401(k) & Qualified Plans Roth IRA Rules
A Roth IRA (Individual Retirement Account) is a type of plan that offers tax-advantaged growth and withdrawals, provided all related rules are followed. There can be many benefits associated with having a Roth IRA—starting with the withdrawals being tax-free, regardless of what the then-current income tax rates are. This, in turn, can provide you with more net spendable income for purchasing the items and services you need and want in retirement.
While there are some similarities between Roth IRAs and traditional IRAs, there are also some key differences. So, it is essential to understand these and how they may impact which type of IRA—if any—is best for you.
How Roth IRAs Work
Unlike a traditional IRA account, Roth IRAs are funded with after-tax contributions. So, no income tax deduction is allowed for a Roth IRA in the year(s) of the contribution(s). However, the money that is inside of a Roth IRA grows tax-free.
In addition, the withdrawals from a Roth IRA are also free from taxation. So, this can make a substantial difference in the amount of money you have available for other needs and wants.
It is important to note that the earnings in a Roth IRA must be held for at least five years before they come out of the account tax-free. Otherwise, the funds accessed may be taxable to you as ordinary income. You may also incur an additional 10% IRS early withdrawal penalty if you make such withdrawals before turning 59 ½.
Some exceptions to this Roth IRA tax-related rule can include:
– Being age 59 ½ or older
– Being disabled
– Using the funds as a first-time home buyer
Contributions, however, can be withdrawn from a Roth account at any time without tax consequences.
How Much Can You Contribute to a Roth IRA?
Only earned income may be contributed to a Roth IRA. There are two ways investors may earn money that is considered eligible income. These include:
– Working for a company or entity that pays you in salary, bonus(es), commissions, tips, or fringe benefits
– Running your own business or farm
Some other ways to qualify as receiving earned income can include the generation of alimony (that is taxable), as well as receiving military differential pay, or untaxed combat pay. Investment income that is generated from rental property, securities, or other assets is considered “unearned,” so it does not qualify for contribution into a Roth IRA account. The same holds true for child support, unemployment benefits, Social Security retirement income, non-taxable alimony, and wages earned as a prison inmate.
Both traditional and Roth IRAs also impose maximum annual contribution limits. In the tax year 2024, this amount is $7,000 if you are under age 50 and $8,000 if you are 50 or over. These annual contribution maximums apply to the total amount that may be added to an IRA (in 2024). So, if you have more than one IRA account, you must stick to these dollar limits in total (as versus contributing these amounts to each IRA account that you have).
In addition to making a direct Roth IRA contribution, you can transfer or rollover money into a Roth account. For instance, if you have money in a 401(k) or other type of employer-sponsored retirement plan, you could move those funds into a Roth IRA.
If this is the case, though, there could be some tax consequences to be aware of. For instance, moving money from one Roth account to another is considered a non-taxable transaction. But, if you move money from a traditional retirement plan and/or traditional IRA into a Roth IRA, you will be taxed in the year the transfer or rollover was made.
However, it may still make sense, especially in today’s low tax rate environment. This is because you can pay taxes now at a lower rate in exchange for withdrawing funds from the Roth account tax-free in the future. (This can be particularly beneficial if tax rates go up).
Contributions to a Roth IRA (as well as to a traditional IRA) may be made up until the tax-filing deadline of the following year. So, for example, you could make an IRA contribution for 2023 up until April 15, 2024.
Roth IRA versus Traditional IRA
Although there are some similarities between Roth and traditional IRAs, there are also a few key differences. These can include the ability to make pre-tax contributions into a traditional IRA, whereas money going into a Roth has already been taxed.
Also, the money taken out of a traditional IRA could be 100% taxable as income if the contributions went into the account pre-tax and the earnings grew on a tax-deferred basis. None of the money has yet been taxed, so it will be taxable upon withdrawal.
If you withdraw from a traditional IRA before age 59 ½, you could be subject to a 10% “early withdrawal” penalty from the IRS. With a Roth IRA, you can access your principal without penalty, even before age 59 ½.
Traditional IRAs also mandate you start taking money from the account at age 73 (since 2023). A stated minimum must be withdrawn based on the required minimum distribution (RMD) rules. Otherwise, you could face a penalty from the IRS. This penalty is 50% of the amount that should have been taken from the account.
Traditional vs. Roth IRAs
| Traditional IRA | Roth IRA |
|---|---|
| Pre-tax contributions (deducted directly from pre-tax wages) | After-tax contributions (deducted from after-tax income) |
| No income limits for making contributions to a traditional IRA account | Income limits could reduce or eliminate the ability to contribute to a Roth IRA account |
| Tax-deferred earnings | Tax-free earnings |
| Taxable withdrawals (usually 100% of each is taxable) | Tax-free withdrawals |
| Future income tax rates are unknown | Future income tax rates don’t matter (at least concerning a Roth TSP) |
A maximum annual contribution of: – $7,000 under the age 50 – $8,000 if age 50 or older | Annual maximum contribution of: – $7,000 under the age 50 – $8,000 if age 50 or older |
| IRS early withdrawal penalty (if withdrawals are taken before age 59 ½) | IRS early withdrawal penalty (if earnings are taken before age 59 ½) Contributions to a Roth IRA may be withdrawn at any time penalty-free |
| Must start taking RMDs at age 73 | No RMDs at any age |
Many investors have both a Roth IRA and a traditional IRA. If this is the case, it is essential to be mindful of the maximum annual contribution limits, as well as when you may and may not access funds without penalty.
Who Qualifies to Contribute to a Roth IRA?
You are likely eligible to contribute to a Roth IRA as long as you have earned income. In addition, unlike previous traditional IRA mandates, there is no upper (or lower) age limit for contributing to a Roth account. In addition, you are also allowed to contribute to a Roth IRA—even if you are a participant in a retirement plan through your employer.
However, the amount of modified adjusted gross income (MAGI) you earn and your income tax filing status may allow you to contribute only a certain amount to a Roth IRA or possibly even nothing at all.
Roth IRA Income and Contribution Limits for 2024
| Tax Filing Status | Modified Adjusted Gross Income (MAGI) | Roth IRA Contribution Limit |
|---|---|---|
| Married filing jointly (or qualifying widow or widower) | Less than $230,000 | $7,000 (or $8,000 if age 50 or older) |
| $230,000 to $240,000 | Begin to phase out (partial contribution) | |
| $240,000 or more | Ineligible for making direct Roth IRA contributions | |
| Married filing separately (and you lived with your spouse at any time during the year) | Less than $10,000 | Begin to phase out (partial contribution) |
| $10,000 or more | Ineligible for direct Roth IRA contributions | |
| Single, head of household, or married filing separately (and you didn’t live with your spouse at any time during the last year) | Less than $146,000 | $7,000 (or $8,000 if age 50 or older) |
| $146,000 to $161,000 | Begin to phase out (partial contribution) | |
| $161,000 or more | Ineligible for making a direct Roth IRA contribution |
To determine the amount of modified adjusted gross income you have earned, you can use IRS Publication 590-A, or you can go online and visit: https://irs.gov/pub/irs-pdf/p590a.pdf.
How to Fund an IRA—Regardless of Your Income
The Roth IRA rules may preclude higher-income earners from opening or funding this type of account. However, there are strategies available that could allow you to still take advantage of owning a Roth account. One such technique is referred to as the backdoor Roth IRA.
While this is not an official type of account, it is the name of an IRS-sanctioned method for higher-income earners to fund a Roth IRA account—even if their income exceeds the maximum limits for making regular Roth IRA contributions.
There are several ways to create a backdoor Roth IRA. These can include:
– Contributing money to an existing traditional IRA and then rolling over the funds to a Roth IRA account
– Taking an existing traditional IRA account and rolling some of the money into a Roth IRA
– Converting an entire traditional IRA account to a Roth IRA account
– Making an after-tax contribution into a 401(k) plan and then rolling the funds over into a Roth IRA
It is important to remember that you will still typically have to pay taxes on money in a traditional IRA that you are rolling over if it has yet to be taxed. For example, if you are 52 years old and contribute a total of $8,000 into a traditional IRA—and then you roll that $8,000 into a Roth IRA—you would owe tax on the $8,000. In addition, if the $8,000 contribution earns interest or generates a gain, you would also owe tax on whatever amount it generated before moving the money into the Roth account.
In addition, the money that you roll from a traditional to a Roth IRA is not considered to be Roth “contributions.” Instead, these dollars are considered “converted” funds, so waiting five years for penalty-free access to this money would be necessary.
Even though you may have to pay tax on money that is moved from a traditional to a Roth IRA, there can still be many advantages to doing so. One of the primary benefits is the tax-free withdrawals that can be made from a Roth IRA in the future. This can be especially beneficial if income tax rates go up in the future.
In addition, because there are no required minimum distributions (RMDs) needed with Roth IRAs, you can leave your money in the account, allowing it to continue generating tax-free earnings.
Is a Roth IRA Right for You?
Although many enticing features are related to Roth IRAs, these accounts are unsuitable for everyone. So, before you commit to opening and funding a Roth IRA account, it is recommended that you discuss your objectives and your potential IRA options with a financial advisor who is a specialist in retirement income strategies.
If you would like to set up a no-cost, no-obligation talk—either in-person, online, or over the phone—with an IRA expert, please feel free to call us at <phone number>, or you can email us any questions or concerns that you may have by going to <email address>. We look forward to helping you build a tax-efficient retirement savings and income plan that fits your short- and long-term financial objectives.
So, if you would like to set up a time to talk, please contact us at <phone number> or send us an email with any questions that you may have by going to <email address>. We look forward to helping you achieve your short- and long-term financial objectives.
