Disclaimer: This article is for general illustrative purposes and/or informational purposes only. It is not meant to serve as investment advice.
What Is a Roth IRA?
Broadly speaking, a Roth IRA is a type of individual retirement account that allows you to make yearly post-tax contributions from your income. Depending on your Roth IRA, you can invest your contributions in various financial instruments and
The most significant advantage of a Roth IRA is that it allows investments to grow tax-free. It also allows for tax-free withdrawals if certain predetermined conditions are met.
Essentially, a Roth IRA enables you to pay tax on your ordinary income today so that you aren’t taxed on your income in the future. Hence, it is best for those who expect to be in a higher income bracket or pay a higher marginal tax in the future.
Like many retirement savings plans, Roth IRAs are also backed by major financial institutions. A department called the Federal Deposit Insurance Corporation (FDIC) is responsible for insuring Roth IRAs for up to $250,000.
A Roth IRA has strict limitations on your contributions, depending on your earned income. If you are eligible for a Roth IRA, you can only make a contribution of $6,000 if you are under 50 and $7,000 if you are above 50. Moreover, there are income
limits that prevent people from opening a Roth IRA at all if their income is too high.
What Are Roth IRA Contributions?
Roth IRA “contributions” refer to the amount you deposit in your account out of your income. All your contributions to the Roth IRA account have to be made with post-tax income, meaning that contributions are not tax-deductible.
For example, if you make $100,000 a year, a $6,000 contribution to your Roth IRA will only reduce your post-tax disposable income and not your total taxable income that year. However, in other types of retirement accounts where contributions
are tax-deductible, a contribution of $6,000 would reduce your taxable income to $94,000, thus saving you tax in the present.
The only issue with Roth IRA contributions is that the limit for the yearly premiums is relatively small: $6,000 if you are under 50 and $7,000 if you are above 50.
On the other hand, an employer-sponsored Roth 401(k) has a larger annual contribution limit than a Roth IRA. According to the IRS rules and regulations, this IRA contribution limit is subject to change.
What Are Roth IRA Phaseouts?
A Roth IRA phaseout refers to a reduction in your yearly contribution limit to your Roth IRA account due to an increased income.
Remember, your yearly contribution depends on your filing status and modified adjusted gross income (MAGI).
In 2022, to max out your Roth IRA or make a full contribution of $6,000, your income as an individual tax filer should be below $129,000 — or below $204,000 if you file your federal tax jointly with your spouse.
As your income starts rising from this lower tax bracket, your yearly contributions to your Roth IRA account start to decrease. Eventually, you are completely barred from making contributions once your household income falls under a higher tax
bracket, i.e. surpasses $144,000 as an individual taxpayer or $214,000 as a married couple jointly filing for taxes.
The premise behind this restriction is to reduce income inequality. It prevents high-income households from exponentially increasing their savings and getting an unfair advantage while ensuring middle to low-income individuals can continue to
plan for a secure retirement.
Do You Have To Report a Roth IRA?
The IRS claims that “Contributions to a Roth IRA aren’t deductible (and you don’t report the contributions on your tax return).” However, you will have to report any
non-qualified distributions from your Roth IRA on IRS Form 8606.
Even if not required by the IRS, it could be beneficial to show your contributions in order to help track your yearly contributions. Reporting your contributions will also help you verify whether or not you qualify for a Savers Credit, which
we’ll cover in more detail below.
Do You Have To Pay Taxes on a Roth IRA?
A qualified withdrawal from your Roth IRA completely exempts you from paying any income tax or penalties on that withdrawal. Typically, a distribution is considered qualified if you withdraw it after the age limit of 59½ and if you’ve had the
Roth account for at least five years.
Even if you are older than 59 ½ years, you need to have held the account for more than five years. If you make an early withdrawal before holding that account for five years, you will be levied an early withdrawal penalty and will lose out on
However, certain qualifying reasons can let you make earlier IRA withdrawals without any penalties and taxes. These reasons are:
- The Roth IRA owner becomes disabled,
- The owner passes away and the distribution is made to an estate or a beneficiary, or
- The owner withdraws up to $10,000 as a first-time homebuyer.
If you have held the account for less than five tax years, these qualifying reasons allow you to withdraw before you turn 59½ without a 10% penalty. However, you will still have to pay income tax.
(Note that you can withdraw your initial contributions to a Roth IRA at any time without a penalty; these rules only apply to withdrawing investment earnings from your account.)
Any withdrawal that does not meet the above-discussed criteria is considered a non-qualified withdrawal. If you withdraw funds earlier than your retirement, you will be liable for paying income tax, plus a 10% penalty on your earning distribution.
IRS lists various circumstances under “exceptions,” wherein you can avoid paying the 10% additional penalty for any distributions
that are not qualified.
Roth IRA Rules
What Is the Roth IRA Five-Year Rule?
The five-year rule applies to the distributions you make from your Roth IRA. In particular, it states that your Roth IRA account should be more than five years old to avoid taxes on your distributions.
In the case of the first five-year rule, if you are 59 ½ years or older and have had a Roth IRA account for more than five years, you are eligible for tax and penalty-free distributions.
However, if you are younger than 59½ years and have satisfied the five-year rule of holding your account for more than five years, your distributions will be taxed, and a 10% penalty will be charged.
As discussed above, if you are eligible for qualified exemptions, you can avoid the penalty and the tax. However, if you are younger than 59 ½ years and your Roth IRA is less than five years old, you will be charged a penalty and tax.
What Is the Roth IRA Ten-Year Rule?
The ten-year rule dictates that the entirety of an inherited Roth IRA should be withdrawn by December 31 of the 10th year since the owner’s death. The heir can withdraw as many installments as possible, as long as the account balance is 0 by
the end of the 10th year. (If the owner passed away before January 1, 2020, the beneficiaries can either use the lifetime distribution rules that were used before 2020 or the ten-year rule itself.)
There are exceptions to this rule for certain beneficiaries — for instance, if they are the owner’s spouse or are not more than 10 years younger than the owner, disabled, chronically ill, or a minor child (in which case, they will be subject
to the ten-year rule when they reach legal age).
What Happens If You Withdraw Roth IRA Funds and Return Them?
According to the IRS, you can borrow money from your Roth IRA account while avoiding any adverse consequences if you return them within 60 days of withdrawing them. Again, you can withdraw as much of the principal amount as you wish; the 60-day
borrowing rule only applies to the additional earnings you may have borrowed.
This replacement of funds can only happen once per calendar year, per account.
For example, if you have three Roth IRAs, you can borrow from and replace each account once per year, for a total of three replacements.
However, if you miss the 60-day replacement deadline and the withdrawal contains additional earnings, it will be considered a distribution. In that case, you will be liable to pay income tax plus the 10% penalty.
Can You Deduct Roth IRA Contributions From Your Taxes?
By design, you can only contribute post-tax income to your Roth IRA account. This means that your contributions are not deductible from your taxes.
Even though your contributions are not tax-deductible, you might qualify to receive a certain percentage of your contribution as a tax credit.
You can get a Saver’s Credit of up to 50% on your contributions if:
- You are single and your income is below $20,500,
- You file your taxes jointly with your spouse and your collective income is below $41,000, or
- You are the head of a household and your income is below $30,750
As your income increases, the percentage of saver’s credit you get on your contributions decreases. Eventually, when your income crosses $34,000 as a single filer, $68,000 as a married couple, and $51,000 as the head of a household, you receive
0% saver’s credit on your contributions.
How Are Taxes Handled for Self-Directed IRAs?
A regular Roth IRA now allows you to invest in traditional investments like stocks and mutual funds. However, a self-directed Roth IRA (SDIRA) gives you the added benefit of diversification through investing in more alternative asset classes
— while still allowing your investments to grow tax-free like a regular Roth IRA.
These alternative asset classes include real estate, cryptocurrencies, private equity, and even precious metals. This ability to diversify is a great advantage if the stock or bond market is underperforming.
SDIRAs are called “self-directed” because they give you greater control over your investment decisions than you would have with a fund manager controlling your regular Roth IRA.
With Roth SDIRAs, your contributions are post-tax — meaning you pay no tax on all your earnings and distributions when you finally withdraw your money for retirement.
Typically, an SDIRA account is managed by a custodian. Investment decisions are made through your authorization, which gives you more control and freedom over your funds. Overall, having greater control over your investment decisions and diversification
can make a Roth SDIRA a better retirement planning tool than a traditional IRA.
To set up a self-directed IRA, you can work with Dorado to get all the resources you need, including a specialized IRA custodian.
Can You Convert a Traditional IRA to a Roth IRA for Tax Breaks?
Yes, you can convert your traditional IRA to a Roth IRA. However, because your traditional IRA account is based entirely on pre-tax deductible income, you will have to pay taxes on the funds you convert, depending on your marginal tax rate. There
is no limit on how much you can convert from a traditional to Roth IRA, as long as you pay the required taxes.
If you are confident about your investments and think your earnings or capital gains can substantially increase in the future you can consider converting your traditional IRA account to a Roth IRA — and especially a Roth SDIRA. As there is no
required minimum distribution (RMD) limit for this kind of Roth IRA conversion, it will allow your investments to grow tax-free and indefinitely.
The Bottom Line
Ultimately, the right retirement savings account depends on your personal situation. While a traditional IRA lets you save tax today to get taxed in the future, a Roth IRA allows you to pay taxes now to save taxes in the future.
If you think that your income will rise in the future and your marginal tax rate will increase, a Roth IRA might be a good option. Additionally, if you think your investments show great potential and your earnings will rise substantially, a Roth
IRA will let your investment grow tax-free and let you avoid taxes on qualified withdrawals.
Lastly, a Roth SDIRA allows your income to grow tax-free and enables you to diversify through investing in various alternative asset classes, making it an extremely beneficial retirement savings option.