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What Are The Rules of Roth IRA?

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What is a Roth IRA and why is it important

If you want to have financial security when you retire you need to make saving for retirement a priority. The Roth IRA is a great tool that can help you save for retirement. The rules of the Roth IRA are straightforward. However, you need to know all of the rules of the Roth IRA to see if you qualify and to ensure you take full advantage of this unique retirement vehicle.  

The Roth IRA is an individual retirement account created in 1997 and named after Senator William Victor Roth II from Deleware who proposed it to Congress.

The account allows you to set aside after-tax income up to a specified amount each year for retirement investing. After you reach a certain age, both the earnings on the account and withdrawals are taxed. This means the account can achieve huge tax-free growth which is important when it comes to knowing how much you truly have for retirement.

You want to have a tax shelter and a Roth IRA is a great one. Take a look at this calculator provided by Bankrate to see how much you can make on your Roth IRA account.  

Rules of IRA: Limits

Income Limits

There are certain rules for the Roth IRA that you need to be aware of to decide if the Roth IRA is an option for your retirement.

Do I make too much for a Roth IRA?

The first rule of the Roth IRA that you need to know is the income limit. You need to know the income limit to see if you make too much for a Roth IRA. For the year 2020, the income limit for the Roth IRA are as follows:

Source: IRS.gov 

If your filing status is…
And your modified AGI is…

Then you can contribute…
married filing jointly or qualifying widow(er)< $196,000

> $196,000 but < $206,000

> $206,000
up to the limit

a reduced amount

zero
married filing separatelyand you lived with your spouse at any time during the year< $10,000

> $10,000
a reduced amount
zero
single, head of household, or married filing separatelyand you did not live with your spouse at any time during the year<$124,000

>$124,000 but <$139,000

>$139,000
up to the limit

a reduced amount

zero

Source: IRS.gov

Contribution Limits

The rules of the Roth IRA also govern how much you can contribute in a single year. The contribution limits for 2019 and 2020 are the same. These are the total contribution for ALL the IRA accounts you have (traditional + Roth) that you can make combined.

  • Under the age of 50, your contribution limit is $6,000.
  • Age 50 and older, your contribution limit is $7,000.
  • If your taxable compensation, was less than the contribution limit, you can contribute it all to the Roth IRA. 

At what age can you no longer contribute to a Roth IRA?

You can contribute to your Roth IRA as long as you have earned income. There are no rules regarding the age limit for contribution.

Is it ever too late to open a Roth IRA?

Unlike a traditional IRA, there are no rules for a ROTH IRA when it comes to the age of opening. You can open a Roth IRA at any age, even over the age of 70. You can also leave your contributions and investment earnings in the account. There is no forced distribution based on age as long as you are alive.

How does Roth IRA work?

The Roth IRA is an investment retirement account that you set up outside of your employer. Some of the best places to open up a Roth IRA account is either through your bank or through a brokerage firm such as Fidelity or Charles Schwab.

To enroll in a ROTH IRA, you will need to have certain documentation and fill out some paperwork that includes a government form of id and bank information. You will also be asked to fill out beneficiary info so that the firm will know who will inherit the funds that you do not use.

Once you have the account set up, you can then choose the different types of investments you will have in your account. The ROTH IRA is just the type of account, you need to choose which investments will go into it so that your account can grow and take advantage of the power of compounding.

Since this account is for retirement, we recommend choosing diverse low fee index funds that have good track records and align with your risk tolerance. You should be willing to hold these securities for a long time so choose wisely. If you are nervous about which to choose, do your research first or ask for help from a fee-only financial advisor.

How many Roth IRA can you have?

There are no rules of Roth IRA when it comes to the number of accounts you can open. You can have as many Roth IRA’s as you want. However, you are still limited to the contribution limit. The amount of money you contribute across your accounts cannot add up to more than $6,000- $7,000 in one year.

How and When are the Roth IRA withdrawals Taxed?

Person sitting on floor trying to do taxes with calculator and tax forms
Photo by Kelly Sikkema on Unsplash

If you satisfy the requirements of the taxation rules of the Roth IRA your distributions and earnings are not taxed.

Are contributions taxable?

Since you contributed to your Roth IRA with after taxed money, your contributions are not taxed. You can withdraw your contributions at any time without a tax penalty.

However, this is not the same for the income you earned while the contributions were invested.

Are distributions taxable?

Any money that was earned on the account can be taxed and have a 10% penalty if you do not satisfy the 5-year rule or if you are below the age or 59½ before you withdraw earnings.

What is the 5-year rule?

The 5-year rule for ROTH IRA means you have to have contributed to your IRA for at least 5 years before you can withdraw earnings. If you withdraw the earnings and you are under the age of 59½ you are subject to taxes and a 10% penalty. If you are over 59½ you are subject to taxes, but won’t face the 10% penalty.

The 10% penalty rule of the ROTH IRA, can be waived if you qualify under a certain set of circumstances. Here is a list of the circumstances where the 10% penalty can be waived: IRS 10% penalty waived

Withdrawal age is below 59½

If you have had the account for 5 years or more and you withdraw you can avoid taxes and penalties on earnings if the withdrawals are for the following reasons: 

  • You’re withdrawing up to $10,000 to buy your first home.
  • The withdrawal is due to disability.
  • The withdrawal is made to a beneficiary or your estate after your death.

What qualifies as earned income?

The IRS dictates what qualifies as earned income under the rules of the Roth IRA. Earned income includes wages, salaries, bonuses, commissions, tips and net earnings from self-employment. Long-term disability, union strike benefits can also qualify. In addition, payments from certain deferred retirement compensation arrangements can also qualify as earned income under the rules.

Can I open a Roth IRA without earned income?

The rules of the Roth IRA mandate that you must have earned income to open a Roth IRA account. If you have received money from other sources, these funds are not eligible to use to fund your account.

Do I have to report my Roth IRA on my tax return?

Since contributions to a Roth IRA aren’t deductible, you don’t have to report your contributions on your tax return. Also, the qualified distributions or return of money contributed are not subject to taxes either. For the account not to be taxed, the account must have been designated as a Roth IRA when it was opened.

What if I make too much for a Roth IRA, can I still have one?

A backdoor Roth IRA is a strategy brokerage firms use to allow high-income earners the ability to fund a Roth IRA account. People that use a backdoor Roth IRA find different ways to take funds they have in a traditional IRA or a 401k account and convert it into a Roth IRA.

If you are interested in doing it, you should speak to a brokerage firm that manages both Traditional and Roth IRA accounts.

Backdoor Roth IRA and Roth Conversions rules

Since 2010, the IRS has not set an income limit rules to determine who can convert a traditional or 401k to a Roth IRA account. 

In addition to income limits, a backdoor IRA allows you to get around the contribution limit rules of the Roth IRA. There is no yearly limit that you can convert into a Roth IRA. 

However, there are contribution tax rules or Roth IRA that you must follow when you convert your other retirement accounts. The only money you are allowed to have in a ROTH IRA is after-tax earned income. Since traditional IRA and 401k funds are put into your account pre-taxed, any money you roll over into a back door ROTH IRA will be taxed at your current tax rate. After you pay the taxes on the money converted, your money can then grow tax-free. 

To learn more about backdoor ROTH IRA’s check out this article. You can also check out this article from Physician on Fire that shows you how he did his Backdoor Roth with Vanguard.

Conclusion

Although there might seem like there are a lot of rules of Roth IRAs that you must follow the tax advantages you get from having one makes it worthwhile. Only you will be affected by the amount you have in retirement savings so you have to do as much as you can to maximize any account you have. Invest early, make sure the funds you have are low fee and diversified and then reap the rewards of your Roth IRA account.

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