Basic Roth IRA Rules
What are the basic Roth IRA rules?
How do you fund your Roth IRA?
Does the IRS limit your contributions based on your income?
These are the questions you should be asking.
If you're new to the world of Roth IRA investing, you should know that the rules are fairly simple and easy to understand.
Here are the key points you should focus on:
By themselves, these bullets don't tell you much. But collectively, they form a basic outline of the process you'll follow to open, fund, and ultimately benefit from, your Roth IRA.
So let's examine each point individually so you develop a firm grasp of the Roth IRA rules...
What are the basic Roth IRA rules in regard to eligibility?
They're quite simple really.
Unlike some tax-sheltered retirement accounts, your Roth IRA only has one restriction in regard to eligibility - earned income.
You must have earned income in order to make a Roth IRA contribution.
So what is "earned income"?
Basically, it's wages earned from performing a job or a service. Passive forms of income don't count, such as pensions, social security benefits, unemployment benefits, dividend income, interest income, rental income, etc.
Having earned income is really the only requirement for funding your Roth IRA.
Your age doesn't matter. In theory, you can be two years old or one hundred two years old, and as long as you have earned income, you can contribute to your Roth IRA.
For instance, let's say your six month old baby is selected as the next Gerber baby.
Even though your baby is a minor, any income she generates from a Gerber baby photo shoot is still earned income.
In such a scenario, as long as you file a tax return on your baby's behalf, your baby has earned income. And thus, your baby is eligible to open and fund her own Roth IRA.
So is earned income really the only eligibility requirement?
Well... To some extent, your level of income does matter. But as of 2010, it doesn't matter as much as it used to.
Personal Income Rules
The basic Roth IRA rules regarding income set limits on the amount of income you can earn and still make a contribution.
The imposed limits relate to your tax filing status.
Under IRS rules, you can NOT make a Roth IRA contribution of any dollar amount if you earn more than the amounts listed below:
However, if you earn more than the income limits listed above, don't worry.
You can still contribute to your Roth IRA.
Well, in 2010, Congress eliminated the income limit on Roth IRA conversions. In essence, this eliminated the income limit on Roth IRA contributions as well.
Because as long as there's no income limit on Roth IRA conversions, you can fully fund your Traditional IRA with after-tax dollars and then convert your Traditional IRA to a Roth IRA.
For example, let's say you're 42 years old, married, and your income is $249,000 per year.
Under the basic Roth IRA rules, you're prohibited from making a Roth IRA contribution of any amount since you earn more than the $179,000 limit.
However, the IRS allows anyone regardless of income to make non-tax deductible contributions to a Traditional IRA.
So under our scenario, you put $5,000 of after-tax money in your Traditional IRA, and then convert it to a Roth IRA, and...
You just made the maximum contribution to your Roth IRA even though you technically earned too much to contribute!
Please note that the above process can get complicated if you already have a Traditional IRA, so make sure you seek the advice of a qualified financial professional before taking any action.
So what are the basic Roth IRA rules in regard to making contributions?
Aside from the requirement that you make your contributions from earned income, the most important thing to remember is that Roth IRA contributions are made with after-tax dollars.
This means your Roth IRA contributions are NOT tax deductible like contributions to your 401k, Traditional IRA, or other similar retirement accounts.
And while this is a bummer in the short-term, you'll be very happy in the long-term.
Because by paying income taxes on your contributions now, you won't have to pay income taxes on those funds when you withdraw them later in your retirement years.
Maximum Contribution Rules
What are the basic Roth IRA rules concerning your maximum contribution limit?
It mostly depends on your age.
Under the basic Roth IRA rules, your maximum contribution limit is:
But remember, income limits aren't as important as they used to be now that Congress eliminated the income limit on Roth IRA conversions.
In theory, your ability to make a Roth IRA contribution phases out as your income rises past a certain level.
But if you find yourself in that situation, don't automatically assume that you're unable to make the maximum annual Roth IRA contribution.
Seek the advice of a qualified financial professional who can assist you in making non-deductible Traditional IRA contributions and converting those funds to your Roth IRA.
Unfortunately, most people don't have to worry about earning too much to make the maximum Roth IRA contribution.
If you're one of them, the most important thing to remember is your contribute up to $5,000 per year if under the age of 50 and up to $6,000 per year if you're 50 years old or older.
What about the basic Roth IRA rules regarding taxes?
Once you fund your account with after-tax dollars, those funds grow tax free as long as you don't take an early withdrawal.
This tax-free growth is an enormous advantage if you're saving for retirement.
For example, let's say you invest in a new stock which doubles in value in five years. You then sell it, and use all the proceeds to invest in a new stock which doubles in five years. You then sell that stock, and so on and so on...
If you invest a $1,000 at the beginning of such a scenario, how much will you have?
Well, if you're buying and selling those stocks in your Roth IRA, your $1,000 initial investment grows into $32,000 in just 25 years.
But outside of your Roth IRA?
It's a lot less.
Because outside of your Roth IRA, you have to pay capital gains tax each time you sell a stock which appreciated in value.
Assuming just a 10% capital gains tax, the above scenario will only net you $20,995.20 in a regular brokerage account. That's a difference of $11,004.80!
Do you see how tax-free growth can supercharge your retirement savings?
Of course, such a scenario assumes you don't withdraw your funds early...
What are the basic Roth IRA rules concerning withdrawals?
The Roth IRA withdrawal rules are fairly straightforward.
First, you can withdraw your original annual contribution amounts tax-free and penalty-free at any time for any reason.
Because you already paid income taxes on those contributions. Remember, you made after-tax contributions to your Roth IRA, so withdrawing those same contributions is a tax-free, penalty-free event.
However, investment gains, rollover funds, and conversion funds are a different story.
If you withdraw those early, you risk paying income taxes and a 10% early withdrawal penalty.
But if you wait until the proper time, then you can withdraw all the funds in your Roth IRA tax-free and penalty-free.
So when is the proper time?
When you reach age 59 ½ and meet the requirements of the 5 year rule.
The first condition is self-explanatory. You need to wait until at least six months after your 59th birthday before you can withdraw non-contribution funds without taxes or penalties.
But what's the 5 year rule?
The 5 year rule states that you must open and fund your Roth IRA for at least five tax years before you can make a qualified withdrawal.
For example, let's say you open and fund your Roth IRA in 2014. When will you meet the conditions of the 5 year rule?
Because that's the year after five tax years have passed - 2014, 2015, 2016, 2017, and 2018.
In order to withdraw investment gains, rollovers, or conversions from your Roth IRA tax-free and penalty-free, you must meet both conditions...
You need to be at least 59 ½ years old and your account must be open and funded for a minimum of five tax years.
It's a good idea to have a firm grasp of the basic Roth IRA rules before you open your account.
Ignorance of the law can lead to costly mistakes and/or impose a serious setback on your plans for retirement.
But knowing the basic Roth IRA rules provides you with a firm foundation for a lifetime of successful retirement planning.
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