Roth IRA - Explained
What is a Roth IRA?
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Table of ContentsWhat is a Roth IRA?How Does a Roth IRA Work?Eligibility/Requirements for Roth IRA ContributionQualifications for Distributing/Withdrawing Money from Roth IRANon-qualified Distribution/WithdrawalBenefits of Roth IRACons of Roth IRADifferences between the Roth IRA and Traditional IRABottom Line
What is a Roth IRA?
Roth IRA is a special retirement plan that offers valuable tax benefits. Named after Delaware Senator William Roth, Roth IRA was established by the Taxpayer Relief Act of 1997. It offers tax benefits to encourage individuals to save. It offers tax-free contribution and withdrawals. This is contrary to the traditional IRA where both your contributions and withdrawals are subject to taxation. With Roth IRA plan, your contributions will mature tax-free and in retirement, you will also be able to withdraw your savings without it being taxed. However, it is important to note that this type of retirement plan is not for everyone. To qualify for this particular type of retirement plan, it will highly depend on your income.
How Does a Roth IRA Work?
Roth IRA has no specific time limit to be established. It can, therefore, be established at any given time. However, like an IRA contributor, you must adhere to your tax-filing deadline which falls on April 15th of every year. This is because there is usually no deadline extension. Also, the establishment of your Roth IRA must be with an institution that has IRS approval to offer IRA. Such institutions include:
- A bank
- A mutual fund
- Loan and savings & loan associations
- Brokerage company
- Federally insured credit unions
- An Insurance company
Note that institutions differ in terms of service provisions. For instance, some institutions will give you a wide range of investment options from which to choose. Others have limited choices or are rather restrictive. The providers will also vary in terms of fee structure for your Roth IRA. Therefore, it is important that you check their account specifications because some institutions will put a higher minimum account balance while others will have an affordable account balance. If you intend to be a heavy investor who is looking forward to making a good number of trades, then finding an institution with the lowest trading cost will be a good idea. It is your investment preference that will make you choose where you want to put your investment. When establishing an IRA, there are two important documents that you will be provided with as a Roth IRA owner. These two documents provide you with rules and regulations that guide the operation of the Roth IRA. The rules and regulations should be able to help you as the IRA owner to strike an agreement with the IRA custodian. The documents are:
- IRA disclosure statement
- A document showing your IRA adoption agreement and plan.
Eligibility/Requirements for Roth IRA Contribution
Provided you have a taxable income, you can contribute to Roth IRA retirement plan. However, your contribution cannot be higher than earning. For instance, if your income is $4,000, you can only contribute a maximum of $4,000 to a Roth IRA plan.
- Eligible income for Roth IRA contribution
Roth IRA contribution cannot be made in the form of securities or any other form. All the contributions must be made in cash, and this includes cheques. Roth can be funded from the following sources:
- For those employed, compensation eligible to fund a Roth IRA includes:
- Spousal Roth IRA and
- Other amount paid to the person for services done for an employer.
Spousal Roth IRA contribution-This is where an individual establishes a Roth IRA fund for a spouse. The contribution follows the normal rules and limits just like regular Roth IRA. For one to be able to contribute to his or her spouse Roth IRA fund, the following requirements are applicable:
- They should be a married couple who file a joint tax return.
- The contributing spouse must have eligible compensation to be able to contribute to Roth IRA.
- Both spouses total contribution must not exceed the taxable compensation as filed in their joint tax returns.
- For those in self-employment, their contribution should come from their business net earnings which in this case is their compensation. All deduction including self- employment tax, and retirement contributions are made from this compensation.
- The amount received by an individual following divorce decree is taxable and, therefore, eligible for the contribution towards Roth IRA.
- Restricted income for Roth IRA contribution
There are several restrictions towards Roth IRA contribution that can make you not to be eligible for contribution. They are as follows:
- If you are earning a higher income. If your income exceeds the set limit as per the law, then you cannot open a Roth IRA account. However, the traditional IRA can work for you as it has no income limit.
- If your contribution is coming from the following sources:
- Income from any property maintenance including rental income
- Pension income
- Income from interest
- Stock dividends and capital gain
- When IRS sets income limits that decreases or weeds out the amount of money one is allowed to contribute. This then means that the minimum and maximum contribution will vary each year depending on the IRS adjustment. Due to their periodic income limit change, you can at some point find yourself ineligible to contribute towards Roth IRA.
For instance, in 2018, the annual contribution of an individual was $5,500 while in 2019 the contribution rose to $6,000. The following chart shows different contributions for 2018 and 2019 as set by IRS respectively.
|Minimum Amount||Maximum Amount||Minimum Amount||Maximum Amount|
|For single tax filer (head of household or separate filing, and you did not live with your spouse at any time of the year)||$120,000||$135,000||$122,000||$137,000|
|Married and filing a joint tax return||$189,000||$199,000||$193,000||$203,000|
|Married but filing separate returns, and you have lived with your spouse at any time of the year.||$10,000||$10,000||Any amount above zero.|
Qualifications for Distributing/Withdrawing Money from Roth IRA
Withdrawing your contribution from Roth IRA account can be done any time. It is tax-free or penalty-free if you withdraw your Roth contribution only. In this case, there are no restrictions or limits as far as age and duration are concerned. To qualify for account earnings from your contributions, it must have lasted for at least five years from the date of its establishment. The distribution must have occurred under the following conditions:
- The Roth IRA holder is at least 59 years and over.
- Used to purchase or to build the first home for Roth IRA holder or a qualified heir. Note that this is limited to $10,000 per lifetime.
- When the Roth holder acquires a disability.
- After the demise of the Roth IRA holder.
You don't qualify for withdrawal if you do not meet the qualifications specified above. In this case, your withdrawals will be subject to taxation and or 10% as a penalty for early distribution. There are, however, exceptions if the fund is used for the following reasons:
- To pay medical insurance.
- Used for qualified higher education expenses (either the Roth holder himself or his or her dependents).
- If the Roth IRA holder has lost his or her job.
Benefits of Roth IRA
- Withdrawal during retirement is tax-free. Tax, in this case, is paid upfront and, therefore, both your contributions and withdrawals are not subject to taxation. This means, during retirement, you will be able to withdraw all your savings without it being taxed. However, the only time your money will be subject to taxation or penalty is when you withdraw your investment earnings.
- Your investment money in Roth IRA will grow tax-free.
- There is no age limit requirement for Roth IRA contribution as in the case of a traditional IRA where the cut-off for contribution stops at age 70 . With Roth IRA, you can contribute even past retirement age as long as your earning income qualifies you to do so.
- With Roth IRA, you can pass your savings to your heirs of which they can withdraw it without being taxed.
- There are no employer plan restrictions with Roth IRA. This means you do not have to be covered by the employers retirement plan to be able to contribute to this plan. With Roth IRA, you are permitted to contribute the maximum amount in a year as long as you still fall within the income limits.
Cons of Roth IRA
- There are government laws on Roth IRA that limits who can and who cannot contribute to the plan.
- Starters are subject to a low contribution limit.
- In case of a change in the economy, the Roth IRA tax-free rule is likely to change and this may affect the contributors.
Differences between the Roth IRA and Traditional IRA
- Roth IRA contribution and withdrawal are not subject to taxation while Traditional IRA contribution and withdrawal are subject to taxation.
- Roth IRA does not have an age limit when it comes to contribution but with Traditional IRA there is an age limit where one has to be below the age of 70 years.
- There is no compulsory withdrawal when it comes to Roth IRA and you can leave your contribution to continue growing as long as you want. Traditional IRA it demands that you must make a compulsory withdrawal the moment you reach the age of 70 years.
In any available investing options for retirement, Roth IRA is one type of savings plan that stands out above the others. This is because it comes with tax advantages that will enable you to build your wealth over time. Besides, it is also easy to initiate and simple to maintain too.