Understanding Roth IRAs

Last month I wrote about traditional IRAs. There is a second type of IRA known as a Roth IRA. Many do not understand the difference between the two. Like the traditional IRA, a Roth IRA is also an investment you set up to provide funds to you when you retire. Unlike a traditional IRA, however, contributions to a Roth IRA are not deductible, but, if qualified, distributions from the Roth IRA are tax free. The following may help you determine whether you can benefit from setting up a Roth IRA.

How is a Roth IRA set up?

A Roth IRA can be is set up in the same manner as a traditional IRA, but must be designated as a Roth IRA when it is set up. The institution in which you choose to set up the Roth IRA will provide the necessary forms to open the account.

Who is eligible for a Roth IRA?

A Roth IRA can be set up by anyone regardless of their age. However, in order to be eligible to contribute to a Roth IRA the person must have earned income. A person who has no earned income may contribute to a Roth IRA if their spouse has earned income and they file a joint return. Both spouses may contribute to their Roth IRAs, but their combined contributions cannot exceed the taxable compensation reported on the joint return less any contributions made to a traditional IRA and the income limits are satisfied. See links in next paragraph for income limits.

How much can be contributed to a Roth IRA?

If contributions are being made solely to the Roth IRA, the maximum yearly amount that may be contributed to a Roth IRA is the lesser of taxable compensation or $6,000 (for 2021 and 2022). If the person is 50 years old or older, the contribution limit is the lesser of taxable compensation or $7,000. However, the contribution amount is limited if the adjusted gross income is above certain limits. The income limits can be found at:

For 2021: https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2021

For 2022: https://www.irs.gov/retirement-plans/plan-participant-employee/amount-of-roth-ira-contributions-that-you-can-make-for-2022

Do contributions have to be made every year?

No, you are not required to make contributions every year.

Can contributions be made to an IRA and Roth IRA in the same year?

Assuming the taxpayer satisfies the income limitation requirement, and has taxable compensation, contributions can be made to both the traditional IRA and the Roth IRA for the same year. However, the sum of the contributions made to each IRA account cannot exceed the maximum contribution amount ($6,000 or $7,000 if 50 years or older).

What is the deadline for contributing to a Roth IRA?

You can contribute to a Roth IRA at any time during the year and have until the due date of the return to contribute, which is usually April 15. This year the tax return filing due date is April 18. Hence, you have until April to make a contribution for 2021. An extension to file the return until October 15 does not extend the time to contribute to a Roth IRA.

What if you contribute too much to the Roth IRA?

If the contribution to the Roth IRA exceeds the limits, you will incur a 6% excise tax for the excess contribution. If you exceed the limit, but withdraw the excess contribution prior to the due date of the return, including extensions, for the year to which the contribution applies, you will not incur the excise tax so long as you also withdraw any earnings on the contribution.

There are rules regarding the conversion of IRAs and other retirement plans to Roth IRAs, the rollover of retirement plans into a Roth IRA and the recharacterization of contributions. These topics are beyond the scope of this newsletter.

Is the Roth IRA contribution deductible?

No. Contributions to a Roth IRA are not deductible.

What is the benefit of a Roth IRA?

Although the contribution to the Roth IRA is not deductible, the earnings in the Roth IRA accumulate tax free. You can leave the amounts in your Roth IRA for as long as you like. There are no minimum distribution requirements like in a traditional IRA. Additionally, qualified distributions from the Roth IRA are tax free. This means that the earnings/growth of the Roth IRA will never be taxed if the distribution is a qualified distribution.

What is a qualified distribution?

A qualified distribution is one which meets two requirements: (1) the distribution is made no less than 5 years after the Roth IRA was set up AND (2) the taxpayer has reached 59.5 years of age, OR the taxpayer has become disabled, OR the taxpayer has died and the distribution is to a beneficiary OR the distribution is for the purchase of a home which meets the first home purchase rules (up to a $10,000 lifetime maximum).

When can withdrawals/distributions from the Roth IRA be made?

Distributions/withdrawals can be made from the Roth IRA at any time. However, if the qualified distribution rules are not satisfied, a 10% early withdrawal penalty will be imposed on the distribution. There are several exceptions to the early withdrawal penalty. The most common ones are death, disability, qualified higher education expenses, qualified first-time home buyer ($10,000), and certain medical expenses and health insurance premiums. For a full list of exceptions see: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions

Additionally, if the distribution is not a qualified distribution, a portion of the distribution may be taxable. In determining the taxable portion of non-qualified distributions, the IRS has rules regarding the order in which contributions and earnings are considered to be distributed from the Roth IRA.

Must a Roth IRA make distributions?

Unlike a traditional IRA, a Roth IRA is not required to make minimum distributions at any time. However, upon the death of the owner of the Roth IRA, some of the minimum distribution rules of traditional IRAs apply. The rules for inherited Roth IRAs are complicated and can depend on whether the beneficiary is the spouse or an eligible designated beneficiary and whether the distribution at death would be a qualified distribution. These rules are beyond the scope of this article.

The rules regarding retirement plans can be complex. The purpose of this article is to provide an overview regarding Roth IRAs and show some ways in which they differ from traditional IRAs. This article is not meant to replace consultation with a qualified retirement planning professional.

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