Among the selection of retirement accounts available to you as an investor, each has its own set of rules that governs the way your money is treated both at the time you make contributions to the account and the time you withdraw them. The Roth IRA, a type of individual retirement account, is no different. Knowing the rules of a Roth IRA can help you maximize your retirement savings while reducing the amount of taxes you will pay on them.
Learn these five rules of a Roth IRA to get a better grasp on how this type of account can help you grow your retirement nest egg.
- You fund a Roth IRA with after-tax money. Money that you wish to contribute to a Roth IRA can only be contributed after it has been taxed. This is opposite of a traditional IRA, which you fund with pretax money. Unlike a traditional IRA, which prohibits you from contributing after age 70.5, you can keep contributing to a Roth IRA throughout your life.
- Withdrawals from a Roth IRA are tax free. Any qualified distribution you make from a Roth IRA is completely tax free. This is one of the most significant advantages of a Roth IRA—the fact that your money can grow in the account without being subject to tax after the initial tax on the contributions.
- The Roth IRA contribution limit is $5,500. The current annual contribution limit is $5,500 as one of the rules of a Roth IRA. If you are 50 or older, the IRS allows you to make an additional $1,000 in catch-up contributions each year, for a total of $6,500. However, your contribution limit can be restricted by your income (see below).
- Your income can affect your Roth IRA contribution limits. Depending on your tax filing status and your modified adjusted gross income, you may or may not be allowed to contribute up to the $5,500/$6,500 contribution limit of a Roth IRA (or you may not be allowed to contribute at all). For example, if you are married filing jointly or a qualifying widower, and you make $196,000 or more, you are not allowed to contribute at all to a Roth IRA. If you are single, the head of household or married filing separately and you did not live with your spouse at any time during the year, and you make $133,000 or more, then you are also not allowed to contribute to a Roth IRA. See this chart to determine your Roth IRA contribution limit.
- The IRS outlines certain requirements for a Roth IRA distribution to be deemed qualified. A qualified distribution will not incur penalties. Here is how the IRS defines a qualified distribution:
- It must occur at least five years after the owner of the account established and funded it. You can make a distribution from your Roth IRA before the five-year mark, but you will be faced with a 10 percent penalty.
- At least one of these requirements must be met:
- You are at least age 59.5 when taking the distribution.
- The distribution occurs after the Roth IRA holder has become disabled.
- The distribution was put toward the purchase of a first home—up to $10,000.
- The distribution was made to a beneficiary or an estate after the Roth IRA holder’s death.
The Rules of a Roth IRA ultimately work to your advantage in allowing your money to compound free from taxation throughout the duration of your working years.
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