In this week’s post, I explain the basics of a Roth individual retirement arrangement (IRA). A Roth IRA is a special type of account that provides certain tax benefits to people saving for retirement. A Roth IRA is similar to, but distinct from, a traditional IRA, which we discussed in last week’s post.
In summary, a Roth IRA is funded with after-tax dollars (no immediate tax deduction is available). However, all growth in the account is tax-free and all qualified withdrawals are tax-free.
Keep in mind that the type of investment account is distinct from the account’s investment holdings, as we covered in a post from a couple of weeks ago. The account has its own rules and tax treatment independent from the investments held within the account. This post will explore some of the account-level rules and tax treatment for a Roth IRA.
Who can contribute to a Roth IRA?
Roth IRAs are set up by individuals, as opposed to some other types of retirement plans (such as Roth 401ks) that are set up through employers.
Similar to a traditional IRA, only those who have earned income from working can make contributions to a Roth IRA. For example, someone who works for a company and receives a W-2 at the end of the year has earned income and can contribute. However, a retired person who just has income from passive investments (such as stocks and bonds), would not be able to contribute. A spouse who does not work outside of the home can also contribute, assuming their spouse has earned income and they file taxes jointly.
Contributions are also limited to those who have modified adjusted gross income (MAGI) below certain levels. Modified adjusted gross income (MAGI) is calculated by subtracting and adding back certain items to adjusted gross income (AGI). Please note that the calculation of MAGI for determining Roth IRA contribution eligibility is slightly different than how MAGI is calculated for traditional IRA deduction eligibility. Here is the basic formula for Roth IRA MAGI:
The MAGI limits for making a full Roth IRA contribution “phase-out” over a certain level of MAGI – between the lower and upper limits, a partial contribution would be allowed. All limits shown below are for tax year 2022:
If filing with single filing status, a full Roth IRA contribution is allowed with MAGI below $129,000 (phasing out to $144,000).
If filing with married filing jointly status, a full Roth IRA contribution is allowed with MAGI below $204,000 (phasing out to $214,000).
For those who make too much to qualify for “normal” Roth IRA contributions, there is also the option to contribute to a Roth IRA in a more complex way, called a “backdoor” Roth IRA. We will likely cover “backdoor” Roth IRA contributions in a future post.
Other than contributions, a Roth IRA can also be funded by a rollover. A rollover is where assets are transferred from one retirement plan/account to another. Typically, this happens when someone rolls a Roth 401k set up through a former employer over to a Roth IRA.
A Roth IRA can also be funded by a conversion. A conversion is when funds are moved from a traditional IRA (or other type of retirement plan) to a Roth IRA. In many instances a conversion will have tax consequences. We will discuss conversions in a future post.
How much can they contribute?
Similar to a traditional IRA, there is a limit to the amount someone can contribute to a Roth IRA each tax year. For tax year 2022, the limit is $6,000 for anyone under age 50 and $7,000 for those who are age 50 or over. The contribution amount cannot exceed the amount of earned compensation – someone who earns $2,000 at a part-time job cannot contribute a full $6,000 to a Roth IRA, they would be limited by their compensation and can only contribute $2,000.
The $6,000 (or $7,000) contribution limit is aggregated for both traditional IRA contributions and Roth IRA contributions – someone cannot fully fund both a traditional and a Roth, but they can split their $6,000 (or $7,000) between the two IRA types.
Rollovers and conversions are not contributions, so these contribution limits do not apply to them.
Contributions can be made for a tax year up until the tax filing deadline for that tax year. For example, contributions for tax year 2022 can be made from January 1, 2022 up until April 15, 2023 (the tax return deadline for 2022).
How are contributions taxed?
Contributions to a Roth IRA are not tax-deductible, like traditional IRA contributions can be. In other words, after-tax money is being contributed. However, all growth is tax-free and withdrawals are tax-free if all rules are followed, so the after-tax contributions are never taxed again.
Are investment earnings taxed?
Earnings in a Roth IRA are tax-free.
For example, if a Roth IRA account grows from $6,000 to $200,000 over a period of 50 years and throughout that period the account holder buys and sells many different investments within the account, they will still not owe any tax.
This tax-free treatment of all investment growth within a Roth IRA is an especially nice feature when managing a portfolio, because the portfolio can be managed without having to be concerned with adverse tax consequences.
When can withdrawals be taken?
Contributions can always be withdrawn from a Roth IRA without tax and penalty. This is important, because it allows for a lot of flexibility. For example, if someone makes a Roth contribution, then their financial situation suddenly changes, they can always access their contributions.
Earnings can be withdrawn without tax and penalty if they are part of a qualified distribution. A distribution is qualified when both of the following conditions are met:
The account holder has had a Roth IRA open for five years (this is called the “five year rule”).
The account holder has reached 59 and a half years old OR qualifies for an exception.
Non-qualified distributions can be made, but they may be subject to taxes and/or penalties. There are also special rules that apply when making distributions of funds that came from conversions and rollovers – these special rules are beyond the scope of this post.
Another nice feature of a Roth IRA is that withdrawals are never required from the account. This is different from a traditional IRA, where required minimum distributions (RMDs) must start around age 72.
How are withdrawals taxed?
As mentioned above, contributions and qualified distributions can be withdrawn tax and penalty free. This is what can make a Roth IRA so appealing – the owner pays taxes on the contributions now, but never pays taxes on any future growth or withdrawals.
Example of a Roth IRA
Beth contributed $6,000 to a Roth IRA this year. $6,000 is the most she could contribute, because she is under 50 years old. Her contribution is not deductible (she is contributing after-tax money). Her MAGI is $110,000, which is below the $129,000 limit for making direct Roth IRA contributions when filing with single filing status. If this $6,000 grows at 8% a year for 50 years, she will end up with $281,410 in the account. During this period, all investment gains are tax-free. As long as Beth has had a Roth IRA opened for five years and is over 59 and a half years old, all distributions will be tax and penalty free.
Because of the separation between the account and the investments within it (as discussed in a recent post), Beth changes the investments in her account several times without tax ramifications.
Here is a visual:
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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