The Roth Individual Retirement Account (IRA) has been a valuable retirement savings plan since its introduction in 1997. The Roth provides several tax advantages, including both tax-free withdrawals and tax-free growth if certain conditions are met. Retirement planners across the country recommend Roth IRAs as an important part of the retirement savings process. Still, despite the many advantages these retirement accounts have, the Roth IRA isn’t for everyone. In this guide, we will explore some of the advantages of a Roth IRA in planning for retirement and contrast those advantages against potential drawbacks.
What is a Roth IRA?
The Roth IRA was introduced as part of the Taxpayer Relief Act of 1997 in an effort to stimulate retirement savings among U.S. citizens. The effort worked; by 2007, over 50 million taxpayers owned IRAs and had invested $3.3 trillion, of which a sizeable percentage was invested in Roths.
A Roth IRA is set up so that any qualified withdrawals after the age of 59 ½ are tax-free. In many other retirement plans, withdrawals or distributions from the account are considered income, which is taxable. Not so with the Roth. That’s a great advantage for those who can wait until retirement age, and can save thousands of dollars over the life of the account. The account grows tax-free as well. Direct contributions – in other words, the principal – may be withdrawn without taxes or penalties at any time, offering incredible flexibility for account holders. Once retirement age is reached and withdrawals begin, distributions from a Roth do not increase a taxpayer’s Adjusted Gross Income.
Roth IRAs grow in value over time. Because these plans use investments in mutual funds, stocks, and other financial products, their value changes as the stock markets rise and fall in value. In general, Roth IRAs can be expected to grow by 8-12 percent every year, which is a substantial figure especially when compared to many other investment strategies. The key to a Roth IRA is the concept of compounding interest over the lifetime of the account. Compounding interest works like this: interest is earned on the balance in the account, so as that balance gets bigger, the interest gets bigger, too. This happens even if you aren’t making contributions to the account; the value grows whether or not you are adding money to the balance.
Eligible to Contribute to a Roth IRA?
Financial planners have seen a sharp uptick in cases where Roth IRA owners made contributions for many years, only to discover that they were no longer eligible to contribute to these retirement plans. What happened in these cases?
One of the drawbacks to a Roth is that one must earn income in order to make contributions to the account. The account holder must have some type of employment in order to contribute. Because contributions to the accounts come from post-tax dollars, the government sets specific regulations on contributions. Passive sources of income, such as benefits from other retirement plans, Social Security payments, and rental income from real estate investments generally do not qualify as earned income. A common misconception is that if an individual has any type of after-tax income, they can make a contribution to their Roth. Unfortunately, this is not the case; for example, any gains received on the sale of a real estate property or from investment growth cannot be used as a contribution to a Roth, even if those gains came from after-tax funds.
Another potential drawback to owning a Roth IRA is income-based; if an individual makes too much money, he or she is not eligible to contribute to the account. Income limits are as follows to remain eligible to make contributions:
- Taxpayers filing jointly/married have an income limit between $189,000 and $199,000.
- Single taxpayers have an income limit between $120,000 and $135,000.
- Married taxpayers who file separately have a very small income limit – between $0 and $10,000.
The upside is that there is no age limit to contribute to a Roth.
Provided those two criteria are met – that you earn an income and that you earn less than the income limits, you are able to make contributions to your Roth. If you earn income beyond those limits, you are effectively barred from making contributions to your Roth IRA.
Contribution limits also come into play. Taxpayers under the age of 50 are allowed to make up to $5,500 in combined contributions to IRA/Roth IRA accounts each year. One can choose to contribute the full $5,500 to a Roth, or to split contributions up to that amount in multiple IRAs. Taxpayers aged 50 or older in 2018 can contribute an additional $1000 to IRAs, bringing the contribution limit up to $6,500 for the year.
One common scenario many retirement planners face is the concept of contributing to an employer-sponsored retirement plan and also contributing to an individually-owned Roth IRA. Individuals who participate in employer-sponsored plans, including SIMPLE IRAs or Simplified Employee Pensions (SEPs) may still make the full annual contribution to their Roth, provided they do not exceed the income cap for their tax-filing status.
Ineligible Roth IRA Contributions?
With the above information about income requirements, including income limits, it is fairly easy to stay ahead of the game when it comes to contributing to a Roth IRA. However, there are situations where an individual exceeds income limits, or does not have an earned income, and still makes a contribution to the Roth. These are considered excess contributions, and can create issues, including steep penalties.
Provided the mistake is caught by October 15th of the year after the year the contribution was made (for example, by October 15, 2018 for a contribution made for the 2017 tax year), an individual can re-characterize the Roth contribution to a Traditional IRA contribution. This may necessitate setting up a Traditional IRA if an account is not already in place, but this helps diversify the retirement portfolio and is a good step regardless of the situation. Another solution for making an excess contribution is to remove the excess as a “return of an excess contribution”. It is critical that any income that is generated by the excess contribution must also be removed to avoid penalties.
What are the penalties for an excess contribution? For every year they remain in the Roth account, the taxpayer is subject to a penalty of 6%. Excess contributions must be reported to the Internal Revenue Service in one of two ways: on a Form 5329 filed with the individual’s tax return or filed separately as a standalone tax return. This form establishes a statute of limitations which can protect the individual. If, however, the form is not filed in a timely manner or filed at all, the IRS gains the ability to assess penalties all the way back to the year of the contribution, which can include interest gained on the excess contribution. To protect your retirement account from the harsh penalties and loss of value, it is of absolute importance to avoid making excess contributions.