A Roth IRA is an individual retirement account wherein you make tax-free withdrawals and only pay taxes at the time of making contributions to the account. A Roth IRA is a good retirement account for individuals who believe that their taxes are likely to be higher in the future compared to the present. Roth IRAs offer tax-deferred investment growth and withdrawals to individuals in addition to several other benefits. If you are unsure about how opening a Roth IRA may be beneficial for you or wish to know more about its benefits, you can reach out to a financial advisor who may explain the finer points to you in detail.
Read on to know more about the essential features of a Roth IRA:
1. Eligibility criteria to contribute to a Roth IRA
The Internal Revenue Service or IRS limits the contributions made to a Roth account based on income thresholds. For the year 2021, single filers earning $125,000 or less can contribute the maximum amount. In the case of married couples filing their taxes jointly, they can make the maximum contribution if they earn $198,000 or less in 2021. However, married couples filing separately can contribute up to a maximum of $10,000.
2. Contribution limits for a Roth IRA
If you wish to optimize your Roth IRA money, you must know your contribution limits. You can contribute to a Roth IRA for both yourself and your spouse, given you file taxes jointly and if either you or your spouse has a qualified income. The income and contribution limits are reviewed by the IRS at regular periodic intervals. In the year 2021, an individual can make a maximum contribution of $6,000 annually. However, if you are above 50 years of age, you can make an additional contribution of $1,000. Do note that the contribution allowance can only be made on earned income. Earned income includes salary, wages, commission, bonus, freelance earnings, business profits, and money earned from other work opportunities. Another thing to note is that $6,000 for individuals and $7,000 for an individual above 50 years of age are the maximum contribution ceilings for one account or a combination of IRAs. If you make contributions above these criteria, then a penalty of 6% every year will be levied on you by the IRS till the time the error is rectified.
3. Restrictions on Roth IRA withdrawals
Roth IRA places certain restrictions when it comes to withdrawing funds from the account. Although you can withdraw money from your account, it attracts a significant penalty of 10 percent when you do so. Moreover, you’d be liable to pay income tax on your earnings. You can make tax-free withdrawals provided you meet certain conditions. As per the stated rules, you can withdraw funds from your account without attracting any penalty or taxes as long as you have been an account holder for five years or more and if you have reached 59.5 years of age. Moreover, you can avoid paying the 10 percent penalty in certain cases, such as when using the withdrawn funds to pay for qualified education expenses or a down payment on your first home.
4. Withdrawal rules for a Roth IRA
There are certain rules associated with Roth IRAs when it comes to making withdrawals. Say, you have multiple Roth IRA accounts and you wish to make a withdrawal from one of them, in that instance, the IRS would give the distribution from regular contributions. The second distribution would be given from conversions and Roth rollovers (on a first-come-first-serve basis), while the next distribution will come out of earnings on contributions. Even if you’re eligible to withdraw funds without attracting any penalty or taxes, once you’ve completely drawn out your contributions, the next distribution from your earnings or conversions can attract taxes and penalties. This is especially true if the withdrawals are not qualified.
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5. Eligible tax-free withdrawals from a Roth IRA
As stated above, if you withdraw money from your Roth IRA account before completion of five years or when you are younger than 59.5 years of age, then the withdrawals are subject to penalties and taxes. However, in certain instances, early withdrawals can be made free of charge, such as if you’re purchasing your first home (up to $10,000) or paying for post-secondary education.
That said, there are a few other instances where an individual qualifies for penalty-free withdrawals:
- Suffering from permanent disability
- Having more than 10 percent of unreimbursed medical costs
- Paying health insurance premiums during unemployment
You can also withdraw the original amount deposited in your Roth IRA account since taxes on those funds have already been paid and accounted for at the time of contributing. Say, for example, you contributed $5,000 over two years, and the funds grow to $6,000 over the next few years. In this case, you can withdraw the stated $5,000 without incurring any penalties, since taxes on these funds have already been paid at the time of deposit.
6. Maximizing your contributions using the backdoor IRA strategy
If you wish to maximize your Roth IRA contributions, you can make use of the backdoor Roth IRA strategy. Backdoor Roth IRAs are an effective means of maximizing one’s contributions especially in scenarios where the contributor exceeds the maximum income limit thereby, cannot contribute to gain tax-deferred growth of funds. In this strategy, you make an initial contribution to a traditional IRA and then convert that said IRA to a Roth IRA. If you initiate the conversion for funds on which taxes have already been paid, the subsequent conversion can be completely tax-free. However, in the case, wherein those funds have grossed earnings, you may have to pay some minor taxes. For this strategy to work, one must ensure that their traditional IRA account does not have any other money. The backdoor Roth IRA conversion can be made every year to earn important tax benefits.
7. Appointing a beneficiary for your Roth IRA account
A common problem encountered by most folks in a Roth IRA account pertains to missing out on the appointment of beneficiaries. One needs to understand that appointing a beneficiary and a contingent beneficiary for your Roth IRA account is an important task. In case a Roth IRA account does not have any nominee, the account would then have to undergo the process of probate i.e. wherein a will is reviewed to determine its veracity and authenticity. This can result in delays and may also involve payment of fees. In addition, it is a good practice to review the beneficiaries from time to time to make sure that they meet your requirements at each life stage.
8. Using inherited Roth money for non-spousal beneficiaries
Non-spousal beneficiaries must withdraw the required minimum distributions (RMD) within 10 years of the owner’s death due to recent modifications made by the IRS. The RMDs must be withdrawn fully from the Roth IRA funds. Earlier, one could minimize their taxes by spreading the withdrawals of RMDs over the life expectancy of the beneficiary. However, one can avoid payment of taxes if the account is older than five years. Beneficiaries who fail to withdraw the RMD in time are liable to pay a tax penalty of 50 percent on the remaining funds in the Roth IRA account.
To summarize
Keeping your funds in a Roth IRA account until you retire is a sound financial strategy, provided you comply with the said rules and specifications. However, you may not always be able to meet these requirements, since they can be complex. To ensure that you adhere to the rules and regulations and stay on target to achieve your savings goals, it is advised that you hire the services of a professional financial advisor to make the most of your Roth IRA.