What Is Roth IRA? | Roth IRA Rules

Roth IRA: Similar to the traditional IRA, Roth IRA is an individual retirement account which allows an individual to keep aside a specified amount of after-tax income every year. In contrast to the traditional IRA, this arrangement allows earnings and withdrawals after age 59 and a half to be tax free. Eligibility on Roth IRA contributions annually is capped and is conditional upon income restrictions. After-tax dollars fund Roth IRA’s with contributions being non-deductible on taxes. However, you may be eligible for a Saver’s Tax Credit equivalent to 10% to 50% of the contribution which contingent on an individual’s life situation and income. Qualified distributions are tax-free once you start pulling out your funds.

How Does Roth IRA Work?

The money laid out into the Roth IRA grows without any tax just like other individual retirement plan arrangements. Once a taxpayer goes beyond the age of seventy and a half, he or she can contribute as long as they have an earned income. Furthermore, there is no need of a required minimum distribution (RMD) during the lifetime of an account holder implying that the Roth IRA can be maintained indefinitely by the taxpayer. The income level of an individual determines their eligibility for a Roth account. A contribution of up to $6,000 can be made by an individual for the year 2019 to a Roth IRA account. The figure was $5,500 for the previous year. Additional catch-up contributions of up to $1,000 can be made by individuals aged fifty and above by the year end for which the contribution applies. For example, up to $6,000 can be added into contributions for the tax year 2019 by an individual who is under fifty and up to $7,000 can be pitched in for those older than 50. It is important to note that regular Roth IRA contributions cannot be made in the form of securities and have to be in the form of cash which can include checks as well. Nonetheless, a large number of investment options are present within a Roth IRA once the contribution of funds takes place. These include stocks, CDs, mutual funds, bonds, ETFs and money market funds. A number of sources like regular contributions, transfers, spousal IRA contributions, rollover contributions, and conversions can be used to fund a Roth individual retirement account.

There is also an option to “roll-over” most of your pre-retirement payments received from a retirement plan or an IRA. This can be done by depositing the payment within two months (60 days) in another retirement plan or individual retirement account. There is also a possibility to directly transfer the payments by your financial institution or plan to another IRA or plan.

Why Roll Over?

Generally, there is no tax on a retirement plan distribution that is rolled over unless it is withdrawn from the new plan. You save yourself a good deal for the future and your money keeps growing tax-deferred by rolling over.  Except qualified Roth distributions and already taxed amounts, your payment will be taxable if you don’t roll it over and there may also be additional tax imposed unless you are qualified for any of the exceptions on early distributions.

One-rollover-per-year-rule for the Individual Retirement Account

As a general rule of thumb, an individual cannot make more than one rollover within the same one-year period from the same IRA. Furthermore, the IRA to which the distribution was rolled over cannot be used to make a rollover during this one-year period.

Pertaining from January 1, 2015, regardless of the number of IRA’s an individual owns, only one rollover can be made from one IRA to another IRA or the same in any given one year period. IRA-to-plan rollovers, plan-to-plan rollovers, rollovers from traditional IRAs to Roth IRAs, plan-to-IRA rollovers and trustee-to-trustee transfers to another IRA are excluded from the one-rollover-per- year rule.

Types of distributions that can be rolled over:

IRA’s: Except for the required minimum distribution or excess contributions distribution and related earnings distribution, all or any part of any kind of a distribution can be rolled over.

Retirement plans: With the exception of the following, any or all parts of any distribution of an individual’s retirement plan can be rolled over:

  • Dividends received from employer securities
  • Hardship distributions
  • Loans which are considered as a distribution
  • Required minimum distributions
  • Excess contributions and related earnings’ distributions
  • Distributions that are part of series’ of substantially equal payments
  • Deemed distributions which are S corporation allocations in reality
  • Withdrawals from automatic contribution arrangements
  • Distributions to pay for life insurance, accident or health

How to Establish a Roth IRA?

  • An institution having the IRS approval to offer IRA’s is eligible to establish a Roth IRA. These institutions include federally insured credit unions, banks, savings and loan associations, and brokerage companies. It is common for individuals to open their IRA’s with brokers.
  • A Roth IRA can be set up at any given point of time but a given tax year’s contributions must be made by the tax-filing deadline by the owner of the IRA. The deadline is typically April 15 of the next year, additionally, tax-filing extensions are not valid.

Two basic documents – the IRA disclosure statement and the IRA adoption agreement and plan document must be provided when an IRA is established to the IRA owner.

Roth Compensation: Do You Qualify For It?

  • Wages, bonuses, commissions, salaries and other amounts paid by the employer for services extended by an individual are eligible compensations to fund a Roth IRA for those working for an employer.
  • The amount displayed in Box 1 of an individual’s Form W-2 is generally the eligible compensation.
  • In the case of an individual involved in a partnership or a self-employed individual, the individual’s net business earnings, minus any sort of deduction allowed for contributions made on the individual’s behalf to retirement plans which are further slashed by 50% of the individual’s self-employment taxes are considered as compensation.
  • Taxable amounts received by an individual due to a divorce decree are other forms of compensation which qualify for the purpose of contributing to a Roth IRA.
  • Interest income, stock dividends and capital gains, rental income or other profits from property maintenance and pension or annuity income are not eligible forms of compensations for contributing towards a Roth.

Eligibility Requirements

A Roth IRA can be contributed by anybody who has taxable income as long as their filing status and modified adjusted gross income meets certain requirements. Individuals with a certain amount of annual income above the standard adjusted periodically by the IRS become ineligible to contribute.

The figures for 2019 are as follows:

Filing Status Income Range for 2019
Married couples, filing jointly Minimum of $193,000 but below $203,000
Married, lived with the spouse at any point of time during the year but filing the tax return separately More than zero but below $10,000
Single, married or head of household but filing individually without having lived with the spouse at any point of time during the given year Minimum $122,000 but below $137,000

Withdrawals: Qualified Distributions

  • Contributions from your Roth IRA can be withdrawn at any given point of time both tax and penalty-free.
  • Irrespective of an individual’s age or duration of holding an amount in their account, the distribution isn’t considered taxable income if they withdraw only the amount of their Roth contributions. Additionally, this distribution won’t be subject to penalty.
  • Roth withdrawals are made on the basis of first in, first out (FIFO), which implies that any withdrawals made come first from contributions. Therefore, until all contributions are withdrawn, the earnings are not considered withdrawn.
  • Once the Roth IRA owner establishes and funds his/her first Roth IRA, that is when distribution of account earnings become eligible and this distribution must occur at least under one of the following conditions:
  • At the time the distribution occurs the Roth IRA holder must be at least 59 and a half years old.
  • The Roth IRA holder or an eligible member of the family can use the distributed assets to purchase, build or rebuild their first home and the amount is limited to $10,000 per lifetime.
  • Once the Roth IRA holder becomes disable is when the distribution occurs.
  • The beneficiary of the Roth IRA holder receives the assets after the Roth IRA holder’s death.

Withdrawals: Non-Qualified Distributions

  • A non-qualified distribution is a withdrawal of earnings which does not meet the requirements mentioned above and it may be liable to income tax or an early distribution penalty of 10%.
  • However, there may be exceptions if the funds are utilized:
  • Unreimbursed medical expenses.
  • For paying medical insurance.
  • Qualified high-education expenses.
  • Oh, and there is yet another discrepancy for earnings: The amount withdrawn from your contributions made within the current tax year are considered “never made” including any earnings you made on those contributions. For instance, if an amount of $500 is generated on your contribution of $5,000 in the current year, you will be able to withdraw the entire $5,500 tax-free and penalty-free provided that the distribution is taken prior to the due date of your tax filing.

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