A Roth IRA works differently than a traditional IRA and provides different benefits. First, contributions to a Roth IRA are never tax-deductible. Contributions are made with after-tax dollars. You can leave amounts in your Roth IRA for as long as you live; however, your designated beneficiary will be subject to RMD requirements on the amount inherited. Once certain requirements are met, the contributions and earnings from a Roth IRA are federal income tax-free when withdrawn, allowing you to keep more of your money for retirement.
Who is eligible?
You must have earned income to contribute to a Roth IRA. In addition, you must meet certain income limits.
Qualified vs. nonqualified distributions
Keep in mind that distributions from a Roth IRA must meet certain criteria to qualify for federal income tax-free status. A qualified distribution is any payment or distribution from a Roth IRA that meets the following requirements:
1. It is made after the five-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
2. The payment or distribution is made:
- a. On or after the date you reach age 59½,
- b. Because you are disabled,
- c. To a beneficiary or to your estate after your death, or
- d. As a qualified first-time homebuyer, up to a maximum lifetime limit of $10,000.
If you receive a distribution from your Roth IRA that does not meet the IRS definition of a qualified distribution, part of the withdrawal may be taxable. To determine whether any portion of a distribution is taxable, the IRS has established an order in which monies in a Roth IRA are to be distributed:
1. Regular contributions, followed by
2. Conversion or rollover contributions, and finally
Withdrawals from earnings are subject to income tax and, if made prior to age 59 1⁄2, may be subject to an additional 10% federal income tax. Certain rules apply to conversions and rollovers. Be sure to consult a tax professional when considering Roth IRA withdrawals in any of these situations.
How much can I contribute to a Roth IRA?
Your ability to contribute to a Roth IRA is determined by your taxable compensation for the year. In 2020, your annual contribution limit is generally the lesser of:
• $6,000 or 100% of your taxable compensation for the year — if you are under age 50
• $7,000 or 100% of your taxable compensation for the year — if you are age 50 or older
Roth IRAs offer:
- Tax-deferred growth — This creates the potential for assets to increase faster than they would in a comparable taxable investment account.
- Tax-free income — After you have held any Roth IRA for at least five years, withdrawals made after age 591/2 are federal income tax free, including the withdrawal of tax-deferred growth.
- No RMDs — You will never have to take distributions during your lifetime.