Quick Recap: Roth vs. Traditional IRA:
What are the main differences between a Roth IRA and a Traditional IRA? Contributions to a Roth IRA are not tax-deductible when you make them. However, the distributions can be tax-free. This tax-free status for distributions applies to both the original investments and the gains on them, assuming you are over age 59½ when you withdraw the funds and that the account is at least five years old.
In 2020 you can contribute up to $6000 per year if you are under 50 and $7000 per year if you are over 50.
In contrast, contributions to a traditional IRA are tax-deductible. However, when it comes time to withdraw the funds, you’ll have to pay taxes on them at your current income-tax rate. What’s more, you have to take required minimum distributions (RMDs) on traditional IRAs starting when you reach the age of 72.
Roth IRAs are not subject to RMD requirements. This rule remains if left to a spouse upon death. In 2020, the IRS changed the mandatory distribution rules for non-spouse heirs of IRAs. All funds in the beneficiary’s account must be distributed by the end of the 10th year after the death of the original IRA owner. There are exceptions, such as for spouses, minor children, disabled or chronically ill people, and those not more than 10 years younger than the IRA owner.
Mistakes to Avoid:
- Earning too much to contribute.
- You can earn too much overall to contribute to a Roth IRA. Whether you’re eligible is determined by your modified adjusted gross income (MAGI). When calculating your MAGI, your income is reduced by certain deductions, such as contributions to a traditional IRA, student loan interest, tuition and fees, and foreign earnings.
- The income limits for Roth IRAs are adjusted periodically by the IRS. As of 2020, people who are married filing jointly or a qualifying widow(er) must make less than $196,000 to be able to make the maximum contribution. If you earn between $196,000 and $206,000, you may be able to contribute some money, but the amount is reduced. With earnings above $206,000, no contribution is allowed.
- Taxpayers in 2020 who are filing as single, head of household, or married filing separately (who did not live with their spouse at any time during the year) can contribute to a Roth IRA as long as they earn less than $124,000. The allowed contribution starts phasing out if they earn $124,000 or more and is eliminated entirely above $139,000.
- What if you are married and live with your spouse, but file taxes separately? If you earn more than $10,000, you cannot contribute to a Roth IRA at all. If you made less, you might be able to make a reduced contribution.
- Not Contributing for Your Non-Working Spouse:
- You can’t contribute more to a Roth than you’ve earned in a given year. But there’s an important exception for non-working spouses, as long as you’re legally married and file a joint tax return.
- A spousal IRA allows a non-working spouse to establish an account, and then have the working spouse make contributions to it as well as to their own. Of course, the working spouse’s income has to be enough to cover both contributions. But increasing—perhaps even doubling—your annual contributions is certainly not the worst idea in the world, and could significantly increase a family’s retirement savings over time.
- Contributing Too Much:
- If you have more than one IRA, or your income gets an unexpected boost, you can easily make the mistake of contributing more than the allowable maximum. (Remember, the annual limit of $6,000 or $7,000 including the catch-up provision is for all your IRAs total, not per account.) Exceeding the limit can cost you a penalty of 6% on the excess each year until you rectify the mistake.
- You can avoid the penalty if you discover the mistake before filing your tax return and take the excess contribution, plus any earnings on it, out of the account. (Actually, you can withdraw some or all of your Roth IRA contributions up to six months after the original due date of the return, but you then must file an amended return.) You can also carry over the excess contribution to another tax year, but unless that’s done simultaneously with the correction, it might trigger the penalty.
- Pulling out Earnings Too Early
- The withdrawal rules for Roth funds can be a tad complicated. You can withdraw the amounts you contributed any time, at any age those contributions were made with after-tax dollars. In order to enjoy tax and penalty-free withdrawals on any profits or income the investments generated, a Roth IRA owner must be 59½ years old and have owned the account for at least five years (the “5-year rule”) If you pull the money out before those two milestones, you may owe income taxes and a 10% penalty on any earnings you withdraw.
- In some limited cases, people under 59½ can avoid the early withdrawal penalty (although not the applicable taxes) on earnings. You can, for example, pull out money to cover the costs of certain education expenses or to pay for a first-time home purchase.
- Rolling Over the Money Yourself
- There are two basic ways to rollover funds from a qualified retirement account into a Roth IRA: direct and indirect. The accounts have to be like to like (i.e. Roth 401k to a Roth IRA).
- In a direct rollover, your money is transferred from one account to another electronically, or you receive a check made out in the name of the new account and deliver it.
- With an indirect rollover, you take possession of the money from the old account and deposit it into the new one yourself.
- It’s best to avoid the indirect rollover because so many things can go wrong. The most common mistake people make is missing the 60-day deadline to roll over the money.
- There are two basic ways to rollover funds from a qualified retirement account into a Roth IRA: direct and indirect. The accounts have to be like to like (i.e. Roth 401k to a Roth IRA).
- Not Considering a Backdoor Roth IRA
- If you make too much money to contribute to a Roth, all is not lost. You could instead contribute to a nondeductible IRA, which is available to anyone no matter how much income they earn. (This contribution is made with after-tax dollars, money that has already been taxed.) Then, using a tax strategy called a backdoor Roth IRA, you convert that money into a Roth IRA.
- To avoid tax complications, you should quickly convert the nondeductible IRA into a Roth IRA before there are any earnings on the money. Advisors recommend that you deposit the money into a low-interest-earning IRA account initially to minimize the chance it will earn much before you transfer it.
- You also have the option of converting an existing 401(k) or a traditional IRA to a Roth IRA, using the same backdoor strategy. The advantage of converting is that any earnings after the Roth conversion will no longer be taxable when you withdraw money during retirement. The disadvantage is that you must pay tax based on your current earnings for any money you convert.
- Failing to Withdraw Inherited Roth Money
- This is the new 10-year rule that applies to IRA beneficiaries. Unlike the original owner of a Roth IRA and their spouse, other beneficiaries must take required minimum distributions (RMDs). For non-spousal beneficiaries, they must withdraw 100% of the funds within ten years of the owner’s death.
- In the past, RMDs were allowed to be spread out over the beneficiary’s life expectancy, which helped reduce the tax burden. However, as of 2020, all of the money must be withdrawn within the ten-year period following the original owner’s death.
- In other words, if you inherit a Roth IRA from someone besides your spouse, you will have to start making withdrawals from it, similar to those of a traditional IRA or 401(k). The good news is that no tax is due on the money if the account is over five years old.
- Skipping a Roth Since You Already Have a 401(k)
- The original goal of the IRA was to provide an investment vehicle for Americans who didn’t have a retirement plan through an employer. But there is nothing in the laws preventing you from using both.
- You can contribute up to the maximum in your 401k ($19,500 if under 50 and $25,500 if over 50) and still contribute to a Roth IRA.
- Most employer plans also have a Roth 401k option that will give you the same tax-free benefits. The limits for the Roth 401K are the same for the Traditional 401K, so you could potentially save more Roth funds in the 401k option. These are subject to Required Minimum Distributions (RMDS)
Having a Roth IRA can provide a lot of retirement benefits for both you and your beneficiaries, but pay attention to the rules, so you don’t jeopardize your account’s tax-free status.