With several different types of IRAs, choosing the best one for potential retirement income is vital. Understanding factors such as eligibility, deductibility, distributions, and conversions can help a person’s decision.
According to the IRS, a Roth IRA is a particular type of IRA that is subject to the rules that apply to a traditional IRA.
- Contributions to a Roth IRA cannot be deducted
- Once requirements are satisfied, qualified distributions are tax-free
- Contributions to a Roth IRA can be made after age 70 ½
- As long as the contributor is still living, funds can be left in a Roth IRA
- When the Roth IRA is set up, the account or annuity must be designated as a Roth IRA
- The same combined contribution Roth IRA limit applies to all of the Roth and traditional IRAs
IRA Contribution Limits
For the current year of 2017, the total contributions to all traditional and Roth IRAs:
- cannot be more than $5,500 for those under age 50 and $6,500 for those ages 50 and older, or
- the taxable compensation for the year, if the compensation was less that the dollar limit mentioned previously
These IRA contribution limits do not apply to rollover contributions from another IRA and qualified reservist payments.
Eligibility for Roth IRAs
Eligibility requirements for 2017 contributions to a Roth IRA are based on adjusted gross income. For single taxpayers, their adjusted gross income of up to $118,000 makes them eligible to contribute the full $5,500 annually to a Roth IRA in 2017. If they are over 50, these same individuals can contribute an additional $1,000. For married couples filing jointly, their adjusted gross income of $186,000 allows them to contribute $5,500 annually if under 50, and an additional $1,000 if 50 or over.
When income increases for these groups, the contribution amount for 2017 is gradually reduced to zero. For single taxpayers, this reduction limit is between $118,00 and $133,000. For married couples filing jointly, the reduction limit is between $186,000 and $196,000.
One advantage to a Roth IRA is that contributions can be made even after age 70 ½.
Deductibility for Roth IRAs
Contributions to a Roth IRA are non-deductible. However, the tax advantages of a Roth IRA are realized when these funds are withdrawn. Earnings on Roth IRA contributions accumulate without tax and these distributions are received tax free.
Qualified Distributions for Roth IRAs
Not included in gross income, the qualified distributions from a Roth IRA are not subject to the additional 10% penalty tax for early withdrawal. To be a tax-free qualified distribution two tests must be met:
- The distribution must occur more than five years after the individual first contributed to the Roth IRA, and
- The individual must be 59 ½ years old, disabled, deceased, or the funds must be used to purchase a first home with a $10,000 lifetime limit.
Conversion from Traditional IRA to a Roth IRA
If funds are converted from a traditional IRA to a Roth IRA, income taxes must be paid on the converted amount, but there is no premature distribution penalty tax.
Roth IRA Taxation
Taxation rules for a Roth IRA fall into two categories: during life and after death.
During life, contributions are not deductible. Earnings on Roth IRA contributions accumulate tax-free until distributed. Qualified distributions from a Roth IRA are received income tax free and are not subject to a 10% premature withdrawal penalty tax. If the distributions from the Roth IRA do not meet the qualified distribution requirements, they will be included in income to the extent that the distributions are perceived as earnings and may be subject to a hefty 10% premature withdrawal penalty tax.
For distributions made within the first 5 years of the initial Roth IRA contribution, exceptions for those under ate 59 ½ are:
- First-time homebuyer with a $10,000 limit
- Substantially equal periodic payments
- Medical expenses above 7.5% of adjusted gross income
- Health insurance premiums paid by an unemployed contributor
- Higher education expenses
Once a person under age 59 ½ reaches the milestone of distributions made more than 5 years after the first Roth IRA contribution, earnings are still taxable with the exception of death, disability, and first-time homebuyers.
For those who have reached age 59 ½, earnings are taxable only for distributions made within 5 years of the first Roth IRA contribution. There are no 10% penalties subjected to anyone over the age of 59 ½.
At death, the value of a Roth IRA is included in the gross estate of the deceased owner. Additionally, the beneficiary is taxed in the same manner as the owner of the Roth IRA.
Rollovers from IRA to IRA
If a taxpayer has a traditional IRA, those funds can be transferred to a Roth IRA. In addition, these same funds can be transferred from a Roth IRA back to a traditional IRA. No taxes or penalties are issued assuming certain requirements are met:
- A trustee to trustee transfer occurs. This means that the trustee of an existing IRA can transfer funds directly to the trustee of the receiving IRA.
- Done once every 365 days, the funds in an existing IIRA are distributed and rolled over to a receiving IRA within 60 days of receiving the rollover.
Funds cannot be moved from a Roth IRA to a traditional IRA, but funds from a traditional IRA can be transferred to a Roth IRA. For those who have carefully reviewed the benefits of a Roth IRA and decided that this is a better retirement savings option, funds can be moved without penalty.
Advantages of Transferring Funds
The advantages of transferring a traditional IRA to a Roth IRA are:
- Roth IRA qualified distributions are received income tax free
- The portion of the distribution represented by the traditional IRA contributions are not taxable if a non-qualified distribution is taken
- Contributors are not held to the minimum age limit in which funds must be distributed
- The premature distribution penalty tax does not apply to the rolled over amounts
- Roth IRA qualified distributions are not included in determining taxable portions of any Social Security benefits received
As with any IRA decision, seeking the advice of an expert financial advisor is highly recommended.