As your Roth IRA will hold a large percentage of your assets, it’s important to understand its rules.
An incorrect conversion. An ill-timed withdrawal. Not understanding how contribution limits work. There are plenty of mistakes that could cost you thousands.
When it comes to Roth IRA rules, there’s a few things everyone should know.
This article will discuss:
- Roth IRA Rules for Eligibility & Contribution
- Roth IRA Investment Options
- Roth IRA Early Withdrawal Rules
- Roth IRA Rules for Early Withdrawals
- Roth IRA Rules for Conversions
Roth IRA Eligibility & Contribution Rules
Can you contribute to a Roth IRA?
There are three factors.
- The type of income you earn
- The amount of income you earn
- And, your tax filing status
Note: There are no age requirements. Anyone can contribute to a Roth IRA as long as they have earned income and file their taxes a certain way.
First, to contribute to a Roth IRA, you must have earned income.
Income from your job or business are good examples of earned income. Investment income, social security, pensions, retirement distributions are examples of unearned income.
Second, your Marginal Adjusted Gross Income or MAGI determines the amount you can contribute. MAGI is much like your Adjusted Gross Income, with add backs for certain deductions. You can learn more about your MAGI here.
Once you know your MAGI, you can determine your contribution limits with the chart below.
Below are the limits for 2016.
|If your filing status is…||And your modified AGI is…||Then you can contribute…|
|married filing jointly or qualifying widow(er)||
up to the limit
> $184,000 but < $194,000
a reduced amount
|married filing separately and you lived with your spouse at any time during the year||
a reduced amount
|single, head of household, ormarried filing separately and you did not live with your spouse at any time during the year||
up to the limit
> $117,000 but < $132,000
a reduced amount
A few notes:
- If you’re over those limits, your limit is $0
- If you’re filing separately but have lived with your spouse for under a year use the limits for single filers
- If only one spouse has earned income and you file jointly, you’re allowed to make a contributing on behalf of both spouses
Roth IRA Investment Options
There are few restrictions on what you can invest in.
- Antiques and collections
- Life insurance
- Some real estate
There’s a a few more but the list is actually quite small.
This leaves investors with a range of possibilities.
So, it’s not as important to look at what you can invest. Instead, it’s more important to consider what should you invest it.
First off, if you hold your Roth IRA in a mainstream investing house, you’re limited to what they offer.
In most cases, that’s stocks, bonds, and mutual funds.
The options available by most mainstream investment houses, are enough for most investors.
A small minority of investors may benefit from diversifying outside of these asset classes.
You’re allowed to do so in a self-directed IRA.
Who is a self-directed IRA good for?
In general, a professional investor with specific expertise in a certain asset class. They are not not for everyone, which you can learn more about here.
When it comes to investing, the goal is to generate the highest return after expenses. A strategy such as a low-fee target date retirement fund, will outperform most investors. This is a well-proven.
Roth IRA Rules for Early Withdrawal
One advantage of a Roth over Traditional IRA is its flexibility.
In a Traditional IRA a 10% penalty applies to withdrawals before the age of 59 1/2. There are a few exemptions but if you want your money, you’re going to pay 10%.
A Roth IRA is a bit more flexible. With a Roth IRA, you’re allowed to withdraw contributions at any time.
For example, for two years in a row, you contributed $5,000 a year into a Roth IRA.
Through smart investing, your account has grown to $12,000.
The breakdown is:
- Contributions = $10,000
- Earnings = $2,000
- Total = $12,000
In year # 3, you’re hit with unexpected medical bills.
You’ve depleted your savings. Your only source of cash left is inside of your Roth IRA. You’re allowed to withdraw up to $10,000 in cash from your IRA without penalty.
Once you build up your savings, you can’t make up for that $10,000. Once it’s out of the Roth, it’s out for good.
You of course want to do everything possible to not take any early withdrawal. But accidents do happen and a Roth IRA can be a cushion.
This is an advantage for investors who want to:
- Build up an emergency fund,
- And, want to start investing
You can use a Roth IRA as part of your emergency fund. With this strategy, you don’t miss out on making contributions. But keep in mind, you want to adjust your asset allocation based on your risk profile. i.e. you may want to keep 100% in cash investments
Roth IRA Qualified Withdrawal Rules
Once you reach the age of 59 1/2, you can withdraw as much as you want.
There’s no taxes and no penalties for making a qualified withdrawal. One caveat, your account must be open at least five years.
For example, you start contributing to your Roth IRA on your 57th birthday. You then must wait until you 62nd birthday to take a qualified withdrawal.
You do not have to wait five years for you to withdraw contributions.
Upon withdrawal, you lose the tax benefits of an IRA.
For example, you withdraw $100,000 from your Roth IRA to place in a separate investment.
That investment is now taxable.
A big benefit of an IRA, is that there are no Required Minimum Distributions or RMDs. This allows your account to continue to compound tax-free gains, even after you retire.
Roth IRA Rules for Conversions
The goal of investing is to achieve the highest return after taxes and fees.
With that goal in mind, you decided to contribute to either a Traditional or Roth IRA.
By contributing to a Traditional IRA, you took a tax deduction today. By doing so, you assumed your taxes at some point in the future would be lower.
But life does tend to change.
And when once a Traditional IRA, looked like the best choice, now a Roth is the best option.
Luckily, you can convert a Traditional IRA to a Roth IRA.
The benefit is that the funds are not subject to income tax.
The downside is that you pay tax on 100% of the conversion.
Your individual situation depends on whether a conversion will give you the highest after-tax return.
For now, let’s just discuss some the rules:
- Income Limits – Income limits exist for how much you can contribute to a Roth IRA. There are no income limits on conversions.
- 60-Day Rollover Limit – Once you withdraw the funds from your Traditional IRA, you must roll them into your Roth IRA. Transfer that take longer than 60 days, it’s a withdrawal. You would owe income tax, and if under the age of 59 1/2, a 10% penalty.
- Eligible Accounts – You’re not limited to only transferring a Traditional IRA to a Roth IRA. You can rollover other Traditional accounts such as 401(K) and 403(B).
Read more about Roth IRA conversions.