Roth IRA Rules: What To Know for 2021

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Saving for retirement is in — way in. According to a recent report from Fidelity Investments, the average IRA balance by the fourth quarter of 2020 was $128,100 — a 9% increase from the prior quarter and an 11% increase year over year. If you’re part of these impressive statistics or want to be, then you need to know: What are the Roth IRA rules for 2021?

What Is a Roth IRA?

A Roth IRA is a type of individual retirement account. The Internal Revenue Service uses another term, individual retirement arrangements, as a way to describe individual retirement accounts and other tax-advantaged savings options for retirement, including annuities, trusts and custodial accounts — so you may hear IRAs referred to in that context as well.

Roth IRAs offer tax-free growth on your contributions. Withdrawals are also tax-free, as long as they qualify — more on that below.

Roth IRA Rules

Before you fund a Roth IRA, understand the regulations associated with it and how they could impact you, depending on your goals and needs. Here’s a look at the fundamentals.

1. You Must Have Earned Income

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In most cases, you must work for yourself or for someone else — earning a salary, commissions, tips, bonuses and/or taxable fringe benefits. You can also be eligible for a Roth IRA via untaxed combat pay, military differential pay and taxed alimony.

Types of income that will not make you eligible for a Roth IRA include nontaxable alimony, child support, Social Security benefits, unemployment benefits, and wages earned while in a penal institution.

2. Roth IRAs Have Income Limits

This type of retirement account has income limits, unlike traditional IRAs. If your tax filing status is single, head of household or married filing separately (and you didn’t live with your spouse at any point during the year), your modified adjusted gross income must be below $140,000.

However, if your MAGI is at least $125,000, you’re subject to phase-out contributions, meaning that you’ll be able to contribute but not up to the annual maximum.

If you are married and filing jointly or filing as a qualified widow(er), your modified adjusted gross income must be below $208,000. Phase-out contributions begin at a MAGI of $198,000.

If you are married and filing separately, and you lived with your spouse at any point during the year, your modified adjusted gross income must be more than zero. You are ineligible to make a Roth IRA contribution if your MAGI is $10,000 or more.

3. High Earners Have a Workaround

If your earnings exceed the income limits of a Roth IRA, you can establish a backdoor Roth IRA. To do this, you would open a traditional IRA and then either convert it to a Roth IRA or transfer the money to an existing Roth IRA. Be sure you understand the tax implications, because…

4. Roth IRAs Are Funded With After-Tax Money

Traditional IRAs are funded with pretax dollars, which means that you take a tax deduction when you make a contribution. On the other hand, Roth IRAs are funded with post-tax dollars and grow tax-free, meaning that you’ll need to pay taxes on any amount that you transfer to a Roth IRA.

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5. Roth IRAs Have an Annual Contribution Cap

As it is with other retirement accounts, your contributions to a Roth IRA can’t exceed a certain amount per year. In 2021, that number is $6,000 (or $7,000 for those over the age of 50).

6. The Cap on Contributions Applies Across All IRAs

Regardless of the type of IRA you choose or how many IRAs you have open, the annual contribution maximum applies across all of them. This means that if you maintain multiple IRAs of any variety, you can contribute $6,000 total across accounts (or $7,000 total if you’re over age 50). Good news: Rollovers and qualified reservist repayments don’t count as new contributions.

7. Qualified Roth IRA Withdrawals Are Tax-Free

When it’s time to pull the money from your account, only a couple of standard Roth IRA rules apply. First, you need to have held the account for at least five years to take distributions without paying federal taxes. You may also do so if you’re age 59 ½ or older.

8. Unqualified Withdrawals Are Possible, at a Price

If you don’t meet the five-year rule, you may be eligible for a penalty-free (but not tax-free) withdrawal from your Roth IRA for the following reasons:

  • A first-time home purchase (withdrawal can be up to $10,000)
  • Qualified education costs
  • Unreimbursed medical costs
  • Expenses related to a permanent disability
  • Inheritance by your beneficiary in the event of your death

If you want to take a distribution from a Roth IRA but you don’t meet the five-year rule or the eligibility requirements outlined above, you still have the option to withdraw funds. However, you will likely need to pay a 10% penalty for doing so.

9. There Are No Required Minimum Distributions

With a Roth IRA, you are never required to take a distribution — unlike a traditional IRA, in which mandatory distributions take hold eventually. Typically, this is at age 70 ½, but legislation passed in late 2019 specifies that if your 70th birthday is July 1, 2019, or later, you will not be required to take withdrawals until you reach age 72.

10. Front-Loading Can Backfire

Funding a Roth IRA fully for the year as soon as possible in the year, to maximize the power of compound interest, makes great financial sense — except if you anticipate that your income could grow significantly during the year in question.

Good To Know

If you’re expecting to look for a new job, make a career transition, or start a business or side hustle, tread carefully. If you fully fund your Roth IRA early in the year and then experience a leap in income that renders you ineligible for a Roth IRA, you’ll be forced to withdraw the excess and any earnings on it or face a 6% tax rate on the excess contributions.

What Can a Roth IRA Do for You?

The power of an individually held retirement account, like a Roth IRA, is that it can offer peace of mind and added security. You can watch your account grow over time with the assurance that your full balance is at the ready for you, tax-free, if you’re eligible.

Before you invest, however, know how Roth IRA rules apply to you. Remember that an investment vehicle is only as effective as the financial goals it is intended to serve. Understand your earned income profile, current and potential, and operate with an understanding of when and why you may want or need to begin utilizing your contributions.

If you determine that a Roth IRA is the right fit, make sure to time your contributions efficiently. Keep track of how diversified your investment selection is and how it performs over time. If this is done well, a Roth IRA can allow you to have maximum predictability and stability going into your hard-earned retirement years.

John Csiszar contributed to the reporting for this article.

Our in-house research team and on-site financial experts work together to create content that’s accurate, impartial, and up to date. We fact-check every single statistic, quote and fact using trusted primary resources to make sure the information we provide is correct. You can learn more about GOBankingRates’ processes and standards in our editorial policy.

About the Author

Kelli Francis is a writer and content strategist. She started her career with a degree in journalism from the University of Oregon and went on to work in some of the industry’s busiest newsrooms, from The Seattle Times to MSN.com, WebMD and Yahoo. In nearly a decade at Yahoo, she worked as an assistant managing editor at Yahoo Finance, specializing in personal finance content; a producer for Yahoo News; and a managing editor on Yahoo’s home page team. A perennial seeker, Kelli is currently expanding her knowledge of all things finance as a student at The American College of Financial Services. She is also the very proud mom of a wonderful and unstoppable 7-year-old with Autism Spectrum Disorder.  

Roth IRA Rules: What To Know for 2021
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