You might have heard of a Roth IRA account as a savings option.
Still, a standard 401k retirement plan may seem like a waste of time, especially if you’re nearing retirement age and want a steady pension and don’t have as many sources of income to fall back on.
But, if you’re starting work and are at least 21 years old, you might have been offered a traditional 401k, or you might be thinking about a Roth IRA, so with no way to predict the future, where do you place your bets, how will these plans affect you tax-wise?
In this guide, we’ll outline what a Roth IRA is, if it makes sense for you to open one, how it affects your taxes, and things you may want to consider when making your retirement plan.
If you’re uncertain about your savings strategy, with options all around you, read on to gain more clarity.
What Is A Roth IRA?
It’s an Individual retirement account where you pay taxes on money going into your account, where future withdrawals are tax-free because Roth IRA’s are funded by after-tax dollars.
This plan is useful for those who think marginal taxes will be higher in retirement than they are right now, but as it’s difficult to predict what the tax rate will be in the future, most people who use this option usually have a steady source of income and can make contributions which can change periodically from year to year.
Most of these types of savers tend to open this account with a brokerage firm or investment company so they can pick investments like stocks or bonds, and the account can be opened for people of any age.
So if you open one in your twenties, the account will have decades to compound, allowing them to take advantage of compound interest. You contribute to the account in cash and can’t be made in the form of securities or property.
Am I Eligible For A Roth IRA?
Anyone can open a Roth IRA if they meet the income limits and have income from work. Below we have outlined each status and listed the ranges so you can see where you sit and can see what your contribution are likely to look like.
Still, these figures can change from year to year, so it’s best to consult the firm you opened the account with, and they should be able to inform you of any changes.
- If you’re single or the head of a household- If you have an income of less than $129,000, you can make a maximal contribution of $6,000 or $7,000 if you’re aged 50 or over. If you have an income that’s above this and you have up to $144,000 or more, your contributions will be reduced or won’t be allowed.
- If you’re married and filing jointly- The threshold rises to $204,000, so if you have an income less than this, you can contribute up to $6,000, or $7,000 if you’re aged 50 or over. If your income is more, your contribution amount will be reduced or not allowed if it is more than $214,000.
- If you’re married and filing separately- The threshold for this circumstance is $10,000, so if you earn less, your contribution amount is reduced and isn’t allowed if you earn more.
Are Earnings From A Roth IRA Taxable?
The contributions you make towards the IRA don’t entitle you to a tax deduction upfront, which is a big reason why these types of accounts are lucrative, so you benefit on the back end in the form of free tax withdrawals.
You do have to follow the rules on withdrawals which are usually outlined by the institution where you open the account, so that you can avoid any penalty fees.
However, if you withdraw any of the earnings from the account, they might be taxed differently. For withdrawals of earnings to be tax-free, you need to have a Roth account for at least five years, which is a rule that is referred to as the five-year waiting period.
If you don’t satisfy this rule, the money you withdraw will be taxed at the same rate as your normal income.
If you’re under the age of 59½ at the time of the withdrawal, you also may be subject to a 10% tax penalty on early withdrawals.
This rule is turned around if you were to die, so your beneficiaries will not be subject to this penalty, regardless of age, as long as the 5-year waiting period has been met.
What If I Don’t Meet The Five-Year Rule?
If you don’t meet the requirements of the rule, your withdrawal will be considered a non-qualified distribution and typically have that 10% penalty, but there are exceptions if you use the withdrawal in the ways listed below.
- For unreimbursed medical expenses- If the withdrawal is used to pay medical costs that exceed 7.5% of your adjusted gross income for the current year and prior tax years.
- To pay medical insurance- If you’re unfortunate enough to lose your job, you could withdraw what you need to cover the cost, so having the account can be useful. Be sure to check the fine print of your agreement to see if your change of circumstance affects any future deposits or withdrawals.
- For qualified higher education expenses- The withdrawal can be used for higher education expenses of the account owner and their dependents. These expenses can be things like tuition fees, books, and equipment required to attend an eligible educational institution and must be used in the year you make the withdrawal.
As you can see, some circumstances make this type of account lucrative but can have its limitations, especially if you need to access the funds earlier than you had hoped for, and requires some strategy if you’re deciding to use the funds in your account for investment purposes.
Hopefully, knowing the requirements of the account and how to use it without any penalties will make your savings and retirement plan easier to strategize and ensures you can make any decisions with confidence and have those funds around if your circumstances change.