A Guide to the Roth IRA

Roth IRAs are investment accounts that provide tax-free withdrawals in retirement, but contributions can be withdrawn at any time tax and penalty-free as well.  Learn the tax rules that govern these accounts to understand the lesser-known benefits of these unique investment vehicles.

Contribution Rules

Contributions to Roth IRAs are limited based on income, which is different from Traditional IRAs.  To be eligible to make a direct contribution, income must not exceed the IRS thresholds set each year, which vary depending on your filing status.  If your income exceeds the limit, an indirect contribution method known as a “backdoor” contribution can be utilized.

Like Traditional IRAs, you must have earned income to make a contribution.  Earned income is defined as wages earned from work performed as an employee or through self-employment.  Also, like Traditional IRAs, spouses who do not earn wages themselves can contribute to their own accounts if their spouse has earned income.  The only stipulation is that the contribution amount be the lesser of either earned income or the IRS contribution limit.

For 2021, the maximum amount an individual can contribute to all personal IRAs is $6,000.  This is a total amount across all Traditional and Roth IRAs.  If you are age 50 or older, you are permitted to make a “catch-up” contribution of $1,000 each year.  These limits exclude contributions made to SEP and SIMPLE IRA accounts that are offered by employers.  There is also no age restriction for making contributions to a Roth IRA.

The deadline for contributing is the same tax filing date that applies to Traditional IRAs, which is typically in mid-April.  This provides an additional four months to the contribution window each year.  Because contributions can only be made if income is below the IRS threshold, it may be advisable to delay making contributions to your Roth IRA until after filing taxes if your income approaches the limit.

Tax Rules   

Contributions to a Roth IRA are not tax-deductible, meaning they do not reduce the amount of income that is subject to ordinary income taxes.  The amount of your deposit is in effect made from your net (after-tax) income.  For this reason, the accounts are usually more advantageous when your income is lower and the tax deduction you forgo by not contributing to a traditional account is smaller.

Like the Traditional IRA, as the value of the securities in a Roth account grow in value, the earnings and gains that accrue are tax-free, meaning that taxes are not due each year on interest, dividends, or capital gains.  Moreover, securities can be sold at any time and frequency without creating a tax liability for the account holder.

The money distributed from a Roth IRA consists of the amount contributed and earnings.  Ordering rules stipulate that contributions are withdrawn first and are followed by earnings.  Contributions can always be withdrawn tax and penalty-free, but if the account has been opened for less than five (5) years or you are under age 59-1/2, the earnings are subject to ordinary income taxes.  The so-called five-year rule applies no matter your age, which is why it is best to open a Roth IRA as soon as you are able.  Tax years beginning on January 1 and you’ll recall that contributions to IRAs can be made up to the tax filing deadline the following year.  Regardless of when the first contribution is made, the five-year clock starts ticking on January 1 of the tax year in which you make your first contribution, even if that is in mid-April of the following year.  As for penalties, there are primarily two that apply to Roth IRAs and each arises under specific conditions.  They are the 6% penalty on excess contributions and the 10% early withdrawal penalty.

Rules Governing Investment Options

The investment options available in IRAs are the same no matter if the account is Traditional or Roth.  IRAs offer the broadest access to investment options available on the market.  Stocks, bonds, mutual funds, and ETFs are the most common securities used to build investment portfolios, and within an IRA, account holders can choose from a universe of options.

This is different than what is typically found in company-sponsored retirement plans like 401K, 403B, and 457 accounts.  Employer plans tend to limit investment options to mutual funds and company-specific stock.  Moreover, the funds employers make available to employees tend to lack wide-ranging international and bond exposures, which can make it harder to build a diversified portfolio that emphasizes the importance of asset allocation.

Just as critical as the investment options are the fees charged in employer accounts.  The fund options offered may have higher average expense ratios than comparable alternatives found when investing through an IRA.  Administrative fees in company retirement plans can also be significant, especially for small and mid-sized businesses.  Since the impact of fees can have a substantial effect on what remains in your account when you reach retirement, it makes sense to compare your options.

Rollover, Transfer, & Conversion Rules

The same rollover and transfer rules that apply to Traditional IRAs also apply to Roth accounts.  What is most important to remember about rollovers and transfers is that indirect transactions result in the account owner taking custody of the assets.  When this occurs, the 60-day rollover requirement is triggered and no other indirect transactions are permitted for the next 365-days.  Failure to understand these rules and navigate them with care can result in major tax consequences, which is why it is almost never a good idea to perform an indirect transaction.  It is best to review with a financial advisor the options you have with your retirement account when you leave your job.

Conversions on the other hand are unique to Roth accounts and occur when assets held in traditional accounts are distributed and then deposited into a Roth IRA.  The amount withdrawn from the pre-tax account is added to the account owner’s income for the year and taxed accordingly.  When done correctly, this tax strategy allows the account owner to time their withdrawals from the pre-tax account, so that they pay the lowest possible income tax rate on the distribution.  Backdoor Roth contributions are an example of a conversion.  Each conversion transaction performed is subject to a five-year waiting period before the contributed amount can be withdrawn tax-free.

Distribution Rules

The amount contributed to a Roth IRA is always tax and penalty-free when withdrawn.  This provision makes the account a secondary source of funds if an emergency arises and can also be useful if early retirement is a goal.  Distributions of earnings after age 59-1/2 and for accounts that have been open for at least five (5) years are tax and penalty-free.  This is the main advantage of the Roth IRA.

However, distributions of earnings are subject to ordinary income taxes before age 59-1/2, and are also subject to the tax if the account has not been open for at least five years regardless of age.  Prior to 59-1/2, earnings that are distributed are also subject to a 10% penalty.  Based on IRS rules, the following exceptions to the penalty apply to distributions that occur as a result of:

• Unreimbursed medical expense greater than 7.5% of AGI
• Payment of health insurance premiums during a period of unemployment
• Total and permanent disability
• Series of substantially equal periodic payments
• Qualified higher-education expense
• First-time home purchase (limited to $10K)
• IRS tax levy
• Qualified military reservist withdrawal
• Withdrawal for a qualified birth or adoption (limited to $5K per child)

Finally, Roth IRAs are not subject to the required minimum distributions traditional accounts are.  In effect, money in the accounts can remain undistributed for the life of the account owner without creating tax consequences.  This is another advantage of the account that benefits the owner and also anyone who inherits it.