Whether you know it or not, retirement is the biggest savings goal of your life. In order to succeed you need a plan that takes advantage of the tools available. Tools like a Roth IRA help thanks to its tax advantages. But is it a good fit for your retirement plan? This guide covers everything you need to know about the Roth IRA rules and more. If you want to be fully informed, I suggest you look over the traditional IRA rules too.
Why A Roth IRA?
The Roth IRA is a relatively new retirement account introduced back in 1997. The plan was to offer something different from the traditional IRA. To that end, it was a success.
The biggest difference is the Roth uses after tax income. The Roth IRA takes after tax dollars and allows for tax-free growth of that money. That means, the money you put in the IRA is already taxed, so it won’t be taxed when you take it out. In return, you lose the tax deduction you would get with a traditional IRA.
So why is the Roth IRA better? It’s not better, it’s just different from a traditional IRA and both offer advantages. In the end, you should choose the IRA that best sets you up for a successful retirement. Still, a Roth can fill several roles in your retirement plan:
- It’s a compliment to an existing retirement plan you have through work. When you max out that 401k, you can continue to put money in the IRA.
- It’s allows for tax diversification in retirement when combined with a traditional IRA or other tax deferred plan.
- There are no minimum distributions. Since the money you put in is already taxed, the tax code doesn’t need you to withdraw any money, ever.
Whether it fits your retirement plan will depend on several things. Most importantly, you need to be eligible.
Table of Contents
- Roth Eligibility Requirements
- Contribution Rules
- Roth Conversion
- Withdrawal Rules
- Open a Roth IRA
Roth IRA Eligibility
The eligibility rules for a Roth IRA are what sets it apart from the traditional IRA.
One of the biggest benefits of a Roth, is the age requirements. Or, more concisely, a lack of an age requirements. The Roth IRA has no minimum or maximum age limits. In other words, you can put money into a Roth IRA at any age, as long as you meet the income requirements.
The tax code is very specific about minimum and maximum income limits for Roth IRAs. First, you must have earned income to put money in a Roth IRA. And your earned income must be equal to or greater than the Roth contributions you make in a year.
The IRS considers “earned income” to be:
- Self employed income
- Non taxable combat pay
Note: Earned income does not include investment income (dividends, interest, capital gains), business income, rental income, or income from pensions, annuities, or deferred compensation.
With the minimum out of the way, there is a maximum income limit for a Roth. Your earned income for a given year needs to fall between the minimum and maximum limits in order to make contributions.
Roth Contribution Rules
As long as you’re eligible for a Roth IRA you can make contributions. In order to find out exactly how much, you’ll need your MAGI, that’s your modified adjusted gross income, and your filing status for the year. To learn how to find your MAGI, go here.
Every year around October, the IRS announces changes, if any, to the Roth IRA contribution limits for the next year. Generally, increases to the contribution limit and income limits are based on the rise in the cost-of-living index.
The table below lists the most you’re allowed to contribute to a Roth in each given year.
|Tax Year||Max Contribution
||Max Catch Up Contribution (Age 50+)|
|2016||$5,500||Additional $1,000 ($6,500 total)|
|2015||$5,500||Additional $1,000 ($6,500 total)|
|2014||$5,500||Additional $1,000 ($6,500 total)|
|2013||$5,500||Additional $1,000 ($6,500 total)|
|2012||$5,000||Additional $1,000 ($6,000 total)|
If you’re 50 years old or older, in addition to the maximum contribution, you’re allowed to make a catch up contribution each year. Again, your MAGI will decide how much money you can put into a Roth IRA each year.
Income Limits for Full Contribution
In order to make the full contribution each year, the Roth IRA rules state that your MAGI must fall inside the range listed for your filing status in the table below.
|Full Contribution||Single or Head of Household||Married, Filing Jointly||Married, Filing Separately|
|2016||$0 – $117,000||$0 – $184,000||not allowed|
|2015||$0 – $116,000||$0 – $183,000||not allowed|
|2014||$0 – $114,000||$0 – $181,000||not allowed|
|2013||$0 – $112,000||$0 – $178,000||not allowed|
|2012||$0 – $110,000||$0 – $173,000||not allowed|
If you’re MAGI doesn’t fall inside the full contribution limit for a given year, you may still qualify for a partial contribution.
Income Limits for Partial Contribution
It takes some math to figure out your partial contribution limit if you qualify. First, you need to check if you’re MAGI falls inside the partial contribution range.
|Partial Contribution||Single or Head of Household||Married, Filing Jointly||Married, Filing Separately|
|2016||$117,000 – $132,000||$184,000 – $194,000||$0 – $10,000|
|2015||$116,000 – $131,000||$183,000 – $193,000||$0 – $10,000|
|2014||$114,000 – $129,000||$181,000 – $191,000||$0 – $10,000|
|2013||$112,000 – $127,000||$178,000 – $188,000||$0 – $10,000|
|2012||$110,000 – $125,000||$173,000 – $183,000||$0 – $10,000|
At this point, either you qualify or you don’t. If your MAGI is more than the partial contribution range, you have two options: a non deductible contribution to a traditional IRA or a backdoor Roth conversion. It’s a unique case, but still an option for those that qualify.
But, if your MAGI does fall in the partial contribution range, you can use the formula to find out the partial contribution amount.
How to Calculate the Partial Contribution Phase Out Limit
It takes some math to figure out the Roth IRA partial contribution amount.
- Partial Contribution = (max phase out range – magi) x (max contribution/(the phase out range))
For example, in 2013, if you’re under 50 and married, filing jointly with a MAGI of $180,000:
- (max phase out range – magi) x (max contribution/(the phase out range))
- ($188,000 – $180,000) x ($5,500/($188,000 – $178,000))
- ($8,000) x ($5,500/$10,000)
- $8,000 x 0.55 = $4,400
- Round up to the nearest $10
- $4,400 is your allowed partial contribution amount
If math isn’t your strong suit, I put together the partial contribution phase out tables to make it easier.
You must have all your contributions for a given year in by the deadline. Now, you might think that’s the end of the year. That’s not the case. For IRAs, the contribution deadline is the same day your tax return is due. In most years, that means April 15th. There is the rare occasion where the 15th falls on a weekend or holiday, in which case, the deadline gets pushed back to the next business day.
|Tax Year||Contribution Deadline
|2016||April 15, 2017|
|2015||April 15, 2016|
|2014||April 15, 2015|
|2013||April 15, 2014|
|2012||April 15, 2013|
Keep in the mind, the extended deadline gives you an extra 3½ months to max out your Roth IRA each year.
Note: Make sure you specify the correct tax year when putting money in your IRA.
What happens if you contribute more to a Roth IRA than you’re allowed? You could be hit with a 6% excise tax on the extra amount.
Should you add more than you’re allowed in a given year, you have several options including removing the excess (and any earnings on the excess amount) before the deadline or you can apply the excess to a later year. If you choose the latter, you could still get hit with the excise tax.
In addition, if you do nothing, you’ll be hit by the excise tax every year, until the mistake is fixed. It’s best to talk through the options with your tax advisor or CPA beforehand.
One of the unique benefits a Roth IRA has is a Roth IRA conversion. This allows you to convert a traditional IRA to a Roth IRA by paying income tax on the amount you convert. The key point here is you pay taxes on any amount you convert. That part is usually overshadowed by the benefits of a Roth IRA. Except, it can be costly.
You need to carefully compare a number of things both now and at retirement before making a decision. That’s why talking to a CFP and/or CPA is a good idea. When done wrong, you can easily tax yourself out of a successful retirement.
That said, a Roth conversion does have its place, just make sure you weigh the benefits with the consequences.
Roth IRA Withdrawal Rules
The Roth withdrawal rules can be broken down into two areas: the principle contributions and the earnings on those contributions. The withdrawal rules for each are very different.
The Roth IRA rules state that the principle amount can be withdrawn at any time. That means you can withdraw up to the amount you contributed at any time without penalty or taxes. For instance, if you contributed $10,000 to a Roth IRA over the past three years, you could withdraw up to that $10,000 amount penalty free.
But be careful with this since there is no way to put the money back. The ability to raid your retirement plan early does nothing but set your retirement back.
Earnings, however, are subject to completely different rules.
Qualified distribution are normal distributions you’d take for retirement. In order to take a qualified distribution you must meet these requirements:
- Is made five years after you first contributed to the Roth IRA, and
- You’ve reached age 59½
The age limit is self-explanatory. The five-year period, however, can be confusing. For future reference, the five-year period begins on January 1 of the tax year you first made contributions to the Roth IRA. So if you made your first contribution in September 2012, your five-year holding period started on January 1, 2012.
As long as both of those requirements are met, you can withdraw money penalty and tax-free. However, if one or none are met, you’ll be hit with an early withdrawal penalty and possibly taxes on the withdrawn amount.
Early Withdrawal Penalty
Being hit with a penalty isn’t the best use of your retirement money. Despite the unique (and confusing) withdrawal rules of the Roth IRA, the 10% early withdrawal penalty still applies. The penalty, however, only applies to withdrawn earnings. Remember, your principle contributions can be withdrawn without penalty.
What that means is, if you contributed $4,000 to a Roth IRA last year, invested it, and earned 5%, you’d now have $4,200. You decide to withdraw all that money, but you don’t meet the qualified distribution requirements. You’ll be hit with the 10% penalty but only on the earned portion. The principle amount, the $4,000, can be withdrawn penalty free. Only the $200 will be hit with the penalty.
That said, there are exceptions:
- Used for qualifying medical expenses
- Used for health insurance if you’re unemployed
- Used for qualified first time home buyer (up to $10,000)
- Used for qualified higher education expenses
- Make substantially equal periodic payments (SEPP) through the rule 72t distribution
Find out more about these exceptions to the IRA early withdrawal penalty.
Since the money you put into a Roth IRA was already taxed, the government doesn’t need to tax it later. This simple concept removes the need to take any distributions. That’s right, there are no required minimum distributions for a Roth IRA. Simply, your money will continue to grow tax-free as long as you leave it untouched.
This presents some unique opportunities for inheritance and estate planning. It’s best to talk to a qualified estate planner first. You’ll need to consider all the tax costs, for you and your heirs, before going that route.
Open A Roth IRA
The best time to start is now. If you qualify for a Roth IRA and it fits with your retirement goals you have several choices. Remember cost is a big key to growing your money so choose a no-fee Roth IRA. Here’s what I recommend.
TD Ameritrade is the broker I use and recommend. It’s great for new and long-term investors, offering a wide selection of no-load funds and commission free ETFs that fit perfectly with low-cost, long-term retirement portfolios. The built-in retirement tools will keep your savings on track and you can open a Roth IRA in minutes.