The Rules of a ROTH IRA

A ROTH IRA can be a great tool to help you save for retirement and other financial planning needs.  One can argue that establishing and funding a ROTH IRA is one of the best decisions an investor can make.

Why, you ask?

If you follow the prescribed ROTH IRA rules, then all earnings and distributions will be tax-free!

This potential for tax-deferred growth and tax-free withdrawals are what make ROTH IRAs so attractive.

In short, here is how a ROTH IRA works:

  1. You earn income and pay income taxes: All contributions to a ROTH IRA are made with after-tax dollars. Funding a ROTH IRA with after-tax dollars is in stark contrast to its traditional IRA counterpart, which uses pre-tax dollars.  The impact of this trade-off is that you are foregoing a tax deduction now in exchange for tax-free income later.
  2. You open a ROTH IRA and contribute to the account: A ROTH IRA is a specific account type. You can open it at many places, most commonly a bank or an investment institution.
  3. You select your investments: ROTH IRAs are often invested in a collection of mutual funds, stocks, and ETFs (or other investments). Your specific investments should be based on your income, time horizon, risk tolerance, risk capacity, and other pertinent factors.
  4. Your earnings grow tax deferred: As your investments grow in value over time (not guaranteed), all growth is deferred. Even if you buy and sell in the account, no taxes are due.
  5. You take qualified distributions: Assuming that you meet the requirements – all earnings will be tax-free! The more growth you have in the ROTH IRA, the larger the benefit may be.

You can only have so much of a good thing – Contribution and Eligibility Restrictions

Now that I’ve shown you this potentially great thing called a ROTH IRA, I need to share the rub.  Not everyone is eligible, meaning that not everyone can contribute to a ROTH IRA.

Eligibility for a ROTH IRA is dependent on a number of things.  Most notably, you (or your spouse) need to have earned income to contribute in any given year.  No earned income means no ROTH IRA.

ROTH IRAs are also subject to contribution limits and income limits.

Contribution Limits

The maximum eligible contribution per person to a ROTH IRA is $5,500.  For those 50 years of age and older, an additional catch-up contribution of $1,000 is allowed.

Income Limits

While the maximum allowable contributions are detailed above, not everyone can contribute this much.  Eligibility to contribute to a ROTH IRA is subject to earned income limits.  For a couple who is married and filing jointly, a full contribution is allowed, assuming modified adjusted gross income up to $184,000.  A phase out occurs between $184,001 and $194,000.  Also, no contribution is allowed for those with income over $194,000.

For a single tax filer, the phase-out occurs between $117,001 and $131,000.  A full chart of eligibility is below.

2016 2015
Roth IRA Contribution Limit $5,500 $5,500
Roth IRA Contribution Limit if 50 or over $6,500 $6,500
Traditional IRA Contribution Limit $5,500 $5,500
Traditional IRA Contribution Limit if 50 or over $6,500 $6,500
Roth IRA Income Limits (for single filers) Phase-out starts at $117,000; ineligible at $132,000 Phase-out starts at $116,000; ineligible at $131,000
Roth IRA Income Limits (for married filers) Phase-out starts at $184,000; ineligible at $194,000 Phase-out starts at $183,000; ineligible at $193,000

Should Everyone Have A ROTH IRA?

Tax-deferred growth and tax-free income… shouldn’t everyone want a ROTH IRA?  It would seem so, but in reality, a ROTH IRA isn’t right for everyone and a ROTH IRA isn’t the best answer all the time.

However, ROTH IRAs may be particularly beneficial for those who have any of the following goals or situations:

  • Have a long time horizon until they need the money
  • Are in a low tax bracket
  • Expect to be in a higher tax bracket later
  • Looking for tax diversification in retirement
  • Are looking to save for retirement, but may want their contributions back sooner
  • Have too much money in traditional IRAs
  • Have already contributed to a 401(k) and still have extra cash flow
  • Are seeking to avoid/lower required minimum distributions
  • Have the ability to convert with a low tax impact
  • Have after-tax dollars in a traditional IRA
  • Are seeking to pass assets to the next generation

As you can see from this list, there are many reasons to consider a ROTH IRA.  Before doing so, however, you should compare a ROTH IRA with the alternative options.

Why ROTH Now?

For so many reasons, a ROTH IRA can be a great fit for investors of any age.  In fact, based on the reasons listed above, I can make an argument that a ROTH IRA can be right for nearly everyone.

However, that’s not always the case.  A detailed discussion should be held to determine the short and long-term objectives of the money going into a ROTH IRA, as well as the short and long-term tax impact.

Only then can you determine if a ROTH IRA is right for you!

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