A Roth IRA is a qualified individual retirement account that allows you to grow investments tax-free. You contribute money you’ve already paid taxes on, but that means you don’t owe taxes on qualified withdrawals. That’s the reverse of a traditional IRA or 401(k), in which you don’t pay taxes on money you contribute but do owe income tax on any withdrawals. There’s also no required distribution from your Roth IRA, unlike a traditional IRA or 401(k).
Although a Roth IRA doesn’t offer the advantage of letting you reduce your taxable income right now, it can be used in combination with your 401(k) or traditional IRA in retirement to help you cover expenses while keeping your taxable income low.
How Does a Roth IRA Work?
Roth IRAs function exactly like traditional IRAs with some key exceptions. To make an informed retirement planning decision, you should understand those exceptions and why they matter. Here are the details on Roth IRA contribution and distribution tax implications:
- You contribute money that you’ve already paid taxes on — i.e., money from your paycheck after factors such as payroll and Social Security taxes have been withheld — and your money grows tax-free.
- Unlike 401(k)s or traditional IRAs, you cannot deduct your contributions on your federal income tax.
- Once you turn 59.5 and you have had your account for at least five years, your withdrawals will be tax-free.
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Benefits of a Roth IRA
Having a Roth IRA offers several major benefits:
- Reducing taxes in retirement: Because qualified withdrawals from your Roth IRA aren’t taxable income, you can use them in conjunction with a 401(k) and/or traditional IRA to ensure that you’re covering expenses while keeping your tax burden low. If you still have costs after taking your required minimum distributions from a 401(k) or IRA but pulling out more money will push you into a higher tax bracket, you can supplement your income with your Roth IRA and avoid the additional tax hit.
- Higher combined contribution limit: If you have both a Roth IRA and a traditional IRA, you are essentially doubling how much money you can contribute to your individual retirement accounts in a given year. So, although you might be limited to just $5,500 a year for your normal IRA, opening a Roth IRA means you can split $11,000 between the two.
- Taxes now instead of later: The basic function of a Roth IRA is to allow you to pay taxes now so you can avoid them later. So, although a 401(k) or traditional IRA contribution will reduce your taxable income in the present, you might have plenty of reasons to opt to use after-tax income now. If your adjusted gross income is already low for the year, it might make more sense to pay the lower rate in the present — especially if you already have regular 401(k) contributions.
Roth IRA Contribution Limits
One big difference between a Roth IRA and a 401(k) is the maximum amount you are allowed to contribute per year. For tax year 2018, Roth IRA limits are $5,500 or $6,500 if you are 50 or older. However, that’s increasing to $6,000 and $7,000 for the 2019 tax year — i.e. the tax return you’ll file in 2020. Certain exceptions might apply based on your tax filing status and adjusted gross income.
Income Eligibility Test for Roth IRAs
You must not exceed the Roth IRA income limits established by the IRS, which are based on your adjusted gross income and are the same for both Roth and traditional IRAs. For 2018, the requirements for single filers and married couples are:
Income Eligibility for Roth IRAs
|Filing Status||Adjusted Gross Income (AGI)||Allowable Contribution|
|Married Filing Jointly or Qualified Widower||Up to $193,000||Up to the annual limit|
|$193,000 to $203,000||A reduced amount|
|Married Filing Separately and you lived with your spouse at any time during the tax year||Under $10,000||A reduced amount|
|Single, Head of Household or Married Filing Separately||Under $122,000||Up to the annual limit|
|$122,000 to $137,000||A reduced amount|
Figuring out amounts for incomes between $122,000 and $137,000 for singles or $193,000 and $203,000 is a little complicated. Here’s how to calculate the reduced amounts for those filing situations:
- Start with your AGI and subtract the threshold for normal contributions ($122,000 for single filers or $193,000 for married filing jointly).
- Divide the result by $15,000 or $10,000 if you’re married filing jointly.
- Multiply the result by the maximum annual contribution.
- Your highest allowable contribution is the normal annual limit minus the number you got in step 3.
For example, if your income is $125,000 and you are a single filer:
1. $125,000 – $122,000 = $3,000
2. $3,000 ÷ $15,000 = 0.2
3. 0.2 x $5,500 = $1,100
4. $5,500 – $1,100 = $4,400 = highest allowable contribution
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Roth IRA Distribution Rules
The required minimum distribution rule requires you to begin drawing down your 401(k) or traditional IRA account once you reach 70.5. This rule can have important tax implications as you’ll be forced to either take those distributions as taxable income or pay a steep penalty. Roth IRAs, however, are exempt from this rule. You can continue to make contributions to your Roth IRA indefinitely and there are no mandatory distribution requirements up until your death.
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Roth IRA Early Withdrawal Penalties
Unless an exception applies, any distributions you take from a 401(k) or traditional IRA before you’re 59.5 are subject to a 10 percent early withdrawal tax. The same rules apply to your Roth IRA, but there are certain conditions in which you can take an early withdrawal without the additional penalty, including but not limited to:
- You’re a qualified first-time homebuyer.
- You’re spending the money on qualified higher education costs.
- You’re totally and permanently disabled.
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Comparing Retirement Savings Plans
A 401(k) differs from a Roth IRA or traditional IRA in their maximum allowable contribution amounts — with a much higher cap on a 401(k) than an IRA. Consult this chart which shows the higher contribution amounts allowable with a 401(k) for the 2018 tax year:
|Maximum Retirement Account Contributions for 2018|
|Maximum Contribution up to Age 49||$5,500||$18,500|
|Maximum Contribution Age 50 and Older||$6,500||$24,500|
However, those limits are rising for the 2019 tax year.
|Maximum Retirement Account Contributions for 2019|
|Roth and Traditional IRA||401(k)|
|Maximum Contribution up to Age 49||$6,000||$19,000|
|Maximum Contribution Age 50 and Older||$7,000||$25,000|
Which Retirement Plan Is Better for You? Roth vs.Traditional IRA
You can open a Roth IRA at any bank and at most other financial institutions, such as investment brokerage firms. Some firms might require an initial minimum opening deposit to fund your account, and some might not. Do your research to find the best place to open your Roth IRA.
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John Kinsellagh contributed to the reporting for this article.