An Individual Retirement Account, or IRA, allows you to save for retirement while gaining significant tax advantages. A Roth IRA is a type of IRA that allows you to pay taxes on money going into the account and withdraw both the money you’ve saved and any interest or investment gains tax-free.
The IRS restricts the amount that you can contribute to a Roth IRA in any given year. In 2019 and 2020 the maximum annual contribution is $6000 per year, with an extra $1000 allowed if you are over age 50. The IRS is involved so assume that there are conditions and exceptions!
What Are Roth and Traditional IRAs?
An IRA is an investment account that individuals use to gain tax advantages while setting aside money for retirement. There are several types of IRA. Traditional and Roth IRAs are the most common types. The difference between them lies in the timing of their tax benefits.
- A Traditional IRA lets you deduct your contributions to your IRA from your income taxes. You will pay tax on the money you save when you withdraw it. That immediate advantage is an asset to people who are short of money but still want to put away money for retirement.
- A Roth IRA lets you pay taxes on the money you deposit. You can then withdraw the money, along with any interest or investment gains, tax-free. A Roth IRA appeals to people who have adequate income now and want to defer their tax advantages until they are retired.
You can only contribute to an IRA with money that the IRS considers earned income. Investment income, Social Security benefits and child support are not considered earned income.
You can only establish an IRA with an institution that has been approved by the IRS. Many banks, credit unions and brokerages are authorized to offer IRAs.
Contribution Limits for Roth IRAs
The IRS sets a limit for the amount that you can contribute tax-free to your Roth IRA in any given year. The annual contribution limit for a Roth IRA in 2020 is $6000. If you are over 50 you can contribute $7000. If your income exceeds the standards listed above this contribution may be reduced.
You cannot contribute more than your taxable income for the year. If you have no taxable income you cannot contribute to a Roth IRA. If your taxable income is $4000, you can only contribute $4000. If you contribute more than the permissible amount the IRS can impose a penalty.
If you contributed too much you may withdraw the contributions and file an amended tax return for up to six months. You will pay tax on the amount you withdraw without having to pay a penalty.
Income Restrictions for Roth IRAs
Roth IRAs are designed to encourage middle-class Americans to save for their retirement. The tax advantages they provide are only available to individuals with incomes below certain levels.
- If you are single or the head of a household, you can contribute up to the full allowable amount in 2020 if your income is below $124,000/year. If your income is between $124,000 and $139,000, the amount you can contribute may be reduced. If you earn over $139,000 you cannot contribute.
- If you are married and filing jointly or your spouse is deceased, you can contribute up to the full allowable amount in 2020 if your income is below $196,000/year. If your income is between $196,000 and $206,000, the amount you can contribute may be reduced. If you earn over $206,000 you cannot contribute.
- If you are married and filing separately. you can contribute up to the full allowable amount in 2020 if your income is below $10,000/year. If you earn over $10,000 you cannot contribute. This provision is designed to encourage married couples to file joint returns
These limits are based on your Modified Adjusted Gross Income (MAGI). MAGI is based on the adjusted gross income from your tax return, with additional deductions for items like interest on student loans, expenses for higher education and taxes on self-employment income.
The Advantages of a Roth IRA
A Roth IRA has advantages that most IRAs don’t share.
- A Roth IRA is taxed when the money goes in, not when it comes out. That means any investment gains are tax-free. Many Roth IRA providers will allow you to invest the money in your account. An IRA is usually held for a significant amount of time, so investment gains may be substantial.
- You can keep making contributions to a Roth IRA as long as you have taxable income that’s below the cutoff point.
- You can hold the Roth IRA indefinitely. There is no Required Minimum Distribution when you reach a fixed age. That lets you hold the account until market conditions favor drawing from it.
- A Roth IRA can be inherited. If you die before you exhaust your Roth IRA, your heirs can still use the money tax-free.
Remember that some IRA providers may charge trading fees or restrict your investment options. Check the terms carefully before you open an account.
A Roth IRA is a tax-advantaged investment vehicle designed to encourage middle-class Americans to save for their retirement. A Roth IRA has significant advantages even if the amount you can contribute annually has a cap and the cap is subject to income requirements. Those requirements can change every year, so you should check the requirements every year before deciding what you will contribute.