Roth IRA
A []Roth IRA is an individual retirement account under United States law that is generally not taxed upon distribution, provided certain conditions are met. The principal difference between Roth IRAs and most other tax-advantaged retirement plans is that rather than granting a tax reduction for contributions to the retirement plan, qualified withdrawals from the Roth IRA plan are tax-free, and growth in the account is tax-free.
The Roth IRA was introduced as part of the Taxpayer Relief Act of 1997 and is named for Senator William Roth.
Overview
A Roth IRA can be an individual retirement account containing investments in securities, usually common stocks and bonds, often through mutual funds. A Roth IRA can also be an individual retirement annuity, which is an annuity contract or an endowment contract purchased from a life insurance company. As with all IRAs, the Internal Revenue Service mandates specific eligibility and filing status requirements. A Roth IRA's main advantages are its tax structure and the additional flexibility that this tax structure provides. Also, there are fewer restrictions on the investments that can be made in the plan than many other tax-advantaged plans, and this adds somewhat to their popularity, though the investment options available depend on the trustee.The total contributions allowed per year to all IRAs is the lesser of one's taxable compensation and the limit amounts as seen below :
History
Originally called an "IRA Plus", the idea was proposed by Senator Bob Packwood of Oregon and Senator William Roth of Delaware in 1989. The Packwood–Roth plan would have allowed individuals to invest up to $2,000 in an account with no immediate tax deductions, but the earnings could later be withdrawn tax-free at retirement.The Roth IRA was established by the Taxpayer Relief Act of 1997 and named for Senator Roth, its chief legislative sponsor. In 2000, 46.3 million taxpayers held IRA accounts worth a total of $2.6 trillion in value according to the Internal Revenue Service. Only a little over $77 billion of that amount was held in Roth IRAs. By 2007, the number of IRA owners has jumped to over 50 million taxpayers with $3.3 trillion invested.
In 1997, then-Senator William Roth wanted to restore the traditional IRA which had been repealed in 1986, and the upfront tax deduction that goes with it. Under congressional budget rules, which work within a 10-year window, the revenue cost of giving that tax break to everyone was too high. So his staff limited deductible IRAs to people with very low income, and made Roth IRAs available to others. That slid the revenue cost outside the 10-year window and got the legislation out from under the budget rules.
Economists have warned about exploding future revenue losses associated with Roth IRAs. With these accounts, the government is "bringing in more now, but giving up much more in the future," said economist and Forbes contributor Leonard Burman. In a study for The Tax Policy Center, Burman calculated that from 2014 to 2046, the Treasury would lose a total of $14 billion as a result of IRA-related provisions in the 2006 tax law. The losses stem from both Roth conversions and the ability to make nondeductible IRA contributions and then immediately convert them to Roths.
Differences from a traditional IRA
In contrast to a traditional IRA, contributions to a Roth IRA are not tax-deductible. Withdrawals are tax-free under certain conditions. A Roth IRA has fewer withdrawal restrictions than traditional IRAs. Transactions inside a Roth IRA do not incur a current tax liability.Advantages
- Direct contributions to a Roth IRA may be withdrawn tax and penalty-free at any time. Earnings may be withdrawn tax and penalty-free after 5 years if the condition of age 59½ is also met. Rollover, converted contributions held in a Roth IRA may be withdrawn tax and penalty-free after 5 years. Distributions from a Roth IRA do not increase Adjusted Gross Income. This differs from a traditional IRA, where all withdrawals are taxed as ordinary income, and a penalty applies for withdrawals before age 59½. Even capital gains on stocks or other securities held in a regular taxable account, so long as they are held for at least a year, are generally treated more advantageously than traditional IRA withdrawals, being taxed not as Ordinary Income, but at the lower Long-Term Capital Gain rate. This potentially higher tax rate for withdrawals of capital gains from a traditional IRA is a quid pro quo for the deduction taken against ordinary income when putting money into the IRA.
- Up to a lifetime maximum $10,000 in earnings, withdrawals are considered qualified if the money is used to acquire a principal residence for the Roth IRA owner. This principal residence must be acquired by the Roth IRA owner, their spouse, or their lineal ancestors and descendants. The owner or qualified relative who receives such a distribution must not have owned a home in the previous 24 months.
- Contributions may be made to a Roth IRA even if the owner participates in a qualified retirement plan such as a 401.
- If a Roth IRA owner dies, and his/her spouse becomes the sole beneficiary of that Roth IRA while also owning a separate Roth IRA, the spouse is permitted to combine the two Roth IRAs into a single plan without penalty.
- If the Roth IRA owner expects that the tax rate applicable to withdrawals from a traditional IRA in retirement will be higher than the tax rate applicable to the funds earned to make the Roth IRA contributions before retirement, then there may be a tax advantage to making contributions to a Roth IRA over a traditional IRA or similar vehicle while working. There is no current tax deduction, but money going into the Roth IRA is taxed at the taxpayer's current marginal tax rate, and will not be taxed at the expected higher future effective tax rate when it comes out of the Roth IRA. There is always risk, however, that retirement savings will be less than anticipated, which would produce a lower tax rate for distributions in retirement. Assuming substantially equivalent tax rates, this is largely a question of age. For example, at the age of 20, one is likely to be in a low tax bracket, and if one is already saving for retirement at that age, the income in retirement is quite likely to qualify for a higher rate, but at the age of 55, one may be in peak earning years and likely to be taxed at a higher tax rate, so retirement income would tend to be lower than income at this age and therefore taxed at a lower rate.
- Assets in the Roth IRA can be passed on to heirs.
- The Roth IRA does not require distributions based on age. All other tax-deferred retirement plans, including the related Roth 401, require withdrawals to begin by April 1 of the calendar year after the owner reaches age 70½. If the account holder does not need the money and wants to leave it to their heirs, a Roth can be an effective way to accumulate tax-free income. Beneficiaries who inherit Roth IRAs are subject to the minimum distribution rules.
- Roth IRAs have a higher "effective" contribution limit than traditional IRAs, since the nominal contribution limit is the same for both traditional and Roth IRAs, but the post-tax contribution in a Roth IRA is equivalent to a larger pre-tax contribution in a traditional IRA that will be taxed upon withdrawal. For example, a contribution of the 2008 limit of $5,000 to a Roth IRA may be equivalent to a traditional IRA contribution of $6667. In 2008, one cannot contribute $6667 to a traditional IRA due to the contribution limit, so the post-tax Roth contribution may be larger.
- On estates large enough to be subject to estate taxes, a Roth IRA can reduce estate taxes since tax dollars have already been subtracted. A traditional IRA is valued at the pre-tax level for estate tax purposes.
- Most employer sponsored retirement plans tend to be pre-tax dollars and are similar, in that respect, to a traditional IRA, so if additional retirement savings are made beyond an employer-sponsored plan, a Roth IRA can diversify tax risk.
- Unlike distributions from a regular IRA, qualified Roth distributions do not affect the calculation of taxable social security benefits.
- Roth Conversions not only convert highly taxed IRA income to tax-free income, but if the IRA holds alternative assets such as REITs, Leasing Programs, Oil and Gas Drilling Partnerships and Royalty Partnerships, a Fair Market Valuation or "Substantially Discounted Roth-Conversion" may provide reductions in the conversion income tax by up to 75%, possibly more, depending on assets and the Fair Market Valuation.
- Roth Conversions using the FMV or "Substantially Discounted Roth-Conversion" may reduce the estate tax attributed to IRA's on large estates by up to 75%, or more, depending on the assets held at the time of conversion.
- Roth Conversions main benefit is in the conversion of highly taxed IRA income to tax-free Roth income, however Roth-Conversion income does not add to MAGI, hence reducing the taxpayers Medicare Part B Premiums.
- FMV or "Substantially Discounted Roth-Conversion" may allow the taxpayer to reduce RMDs by up to 75%.
Disadvantages
- Funds that reside in a Roth IRA cannot be used as collateral for a loan per current IRS rules and therefore cannot be used for financial leveraging or as a cash management tool for investment purposes.
- Contributions to a Roth IRA are not tax deductible. By contrast, contributions to a traditional IRA are tax deductible. Therefore, someone who contributes to a traditional IRA instead of a Roth IRA gets an immediate tax savings equal to the amount of the contribution multiplied by their marginal tax rate while someone who contributes to a Roth IRA does not realize this immediate tax reduction. Also, by contrast, contributions to most employer sponsored retirement plans, 403 are tax deductible with no income limits because they reduce a taxpayer's adjusted gross income.
- Eligibility to contribute to a Roth IRA phases out at certain income limits. By contrast, contributions to most tax deductible employer sponsored retirement plans have no income limit.
- Contributions to a Roth IRA do not reduce a taxpayer's adjusted gross income. By contrast, contributions to a traditional IRA or most employer sponsored retirement plans reduce AGI. Reducing one's AGI has a benefit if it puts the AGI below some threshold to make the taxpayer eligible for tax credits or deductions that would not be available at the higher AGI with a Roth IRA. The amount of credits and deductions may increase as the taxpayer slides down the phaseout scale. Examples include the child tax credit, the earned income credit, the student loan interest deduction.
- A Roth IRA contribution is taxed at the taxpayer's current income tax rate, which is higher than the income tax rate during retirement for most people. This is because most people have a lower income, that falls in a lower tax bracket, during retirement than during their working years. By contrast, contributions to traditional IRAs or employer-sponsored tax-deductible retirement plans result in an immediate tax savings equal to the taxpayer's current marginal tax bracket multiplied by the amount of the contribution. The higher the taxpayer's current marginal tax rate, the higher the potential disadvantage. However, this issue is more complicated because withdrawals from traditional IRA or employer sponsored tax deductible retirement plans are fully taxable, up to 85% of Social Security income is taxable, personal residence mortgage interest deduction decreases as the mortgage is paid down, and there may be pension plan income, investment income and other factors.
- A taxpayer who pays state income taxes and who contributes to a Roth IRA will have to pay state income taxes on the amount contributed to the Roth IRA in the year the money is earned. However, if the taxpayer retires to a state with a lower income tax rate, or no income taxes, then the taxpayer will have given up the opportunity to avoid paying state income taxes altogether on the amount of the Roth IRA contribution by instead contributing to a traditional IRA or a tax deductible employer sponsored retirement plan, because when the contributions are withdrawn from the traditional IRA or tax deductible plan in retirement, the taxpayer will then be a resident of the low or no income tax state, and will have avoided paying the state income tax altogether as a result of moving to a different state before the income tax became due.
- The perceived tax benefit may never be realized. That is, one might not live to retirement or much beyond, in which case the tax structure of a Roth only serves to reduce an estate that may not have been subject to tax. To fully realize the tax benefit, one must live until one's Roth IRA contributions have been withdrawn and exhausted. By contrast, with a traditional IRA, tax might never be collected at all, such as if one dies before retirement with an estate below the tax threshold, or retires with income below the tax threshold. Heirs will have to pay taxes on withdrawals from traditional IRA assets they inherit, and must continue to take mandatory distributions. It is also possible that tax laws may change by the time one reaches retirement age.
- Congress may change the rules that allow for tax-free withdrawal of Roth IRA contributions. Therefore, someone who contributes to a traditional IRA is guaranteed to realize an immediate tax benefit, whereas someone who contributes to a Roth IRA must wait for a number of years before realizing the tax benefit, and that person assumes the risk that the rules might be changed during the interim. On the other hand, taxing earnings on an account which were promised to be untaxed may be seen as a violation of contract and completely defeat the purpose of Roth IRAs as encouraging saving for retirement – individuals contributing to a Roth IRA now may in fact be saving themselves from new, possibly higher income tax obligations in the future. However, the federal government is not restricted by the Contract Clause of the U.S. Constitution that prohibits "Law impairing the Obligation of Contracts". By its terms, this prohibition applies only to state governments.
Double taxation
For Canadians with U.S. Roth IRAs: A new rule provides that Roth IRAs and similar plans are considered to be pensions. Accordingly, distributions from a Roth IRA to a resident of Canada will generally be exempt from Canadian tax to the extent that they would have been exempt from U.S. tax if paid to a resident of the U.S. Additionally, a resident of Canada may elect to defer any taxation in Canada with respect to income accrued in a Roth IRA but not distributed by the Roth IRA, until and to the extent that a distribution is made from the Roth IRA or any plan substituted therefor. The effect of these rules is that, in most cases, no portion of the Roth IRA will be subject to taxation in Canada.
However, where an individual makes a contribution to a Roth IRA while they are a resident of Canada, the Roth IRA will lose its status as a "pension" for purposes of the Treaty with respect to the accretions from the time such contribution is made. Income accretions from such time will be subject to tax in Canada in the year of accrual. In effect, the Roth IRA will be bifurcated into a "frozen" pension that will continue to enjoy the benefit of the exemption for pensions and a non-pension that will not.
Eligibility
Income limits
Congress has limited who can contribute to a Roth IRA based upon income. A taxpayer can contribute the maximum amount listed at the top of the page only if their Modified Adjusted Gross Income is below a certain level. Otherwise, a phase-out of allowed contributions runs proportionally throughout the MAGI ranges shown below. Once MAGI hits the top of the range, no contribution is allowed at all; however, a minimum of $200 may be contributed as long as MAGI is below the top of the range. Excess Roth IRA contributions may be recharacterized into Traditional IRA contributions as long as the combined contributions do not exceed that tax year's limit. The Roth IRA MAGI phase out ranges for 2019 are:- Single filers: Up to $122,000 ; $122,000–$137,000
- Joint filers: Up to $189,000 ; $193,000–$203,000
- Married filing separately : $0 ; $0–$10,000.
However, once a Roth IRA is established, the balance in the plan remains tax-sheltered, even if the taxpayer's income rises above the threshold.
To be eligible, one must meet the earned income minimum requirement. In order to make a contribution, one must have taxable compensation. If one makes only $2,000 in taxable compensation, one's maximum IRA contribution is $2,000.
If a taxpayer's income exceeds the income limits, they may still be able to effectively contribute by using a "backdoor" contribution process.
Contribution limits
Contributions to both a Roth IRA and a traditional IRA are limited to the total amount allowed for either of them. Generally, the contribution cannot exceed your earned income for the year in question. The one exception is for a "spousal IRA" where a contribution can be made for a spouse with little or no earned income provided the other spouse has sufficient earned income and the spouses file a joint tax return.Conversion rules
The government allows people to convert Traditional IRA funds to Roth IRA funds by paying income tax on any account balance being converted that has not already been taxed.Prior to 2010, two circumstances prohibited conversions: Modified Adjusted Gross Income exceeding $100,000 or the participant's tax filing status is Married Filing Separately. These limitations were removed as part of the Tax Increase Prevention and Reconciliation Act of 2005.
Traditional IRA conversion as a workaround to Roth IRA income limits
Regardless of income but subject to contribution limits, contributions can be made to a Traditional IRA and then converted to a Roth IRA. This allows for "backdoor" contributions where individuals are able to avoid the income limitations of the Roth IRA.One major caveat to the entire "backdoor" Roth IRA contribution process, however, is that it only works for people who do not have any pre-tax contributed money in IRA accounts at the time of the "backdoor" conversion to Roth; conversions made when other IRA money exists are subject to pro-rata calculations and may lead to tax liabilities on the part of the converter.
For example, if someone has contributed $10,000 post-tax and $30,000 pre-tax to a traditional IRA and wants to convert the post tax $10,000 into a Roth, the pro-rated amount is taxable. In this example, $7500 of the post tax contribution is considered taxable when converting it to a Roth IRA. The pro-rata calculation is made based on all traditional IRA contributions across all the individual's traditional IRA accounts.
Distributions
Returns of your regular contributions from your Roth IRA are always withdrawn tax and penalty-free. Eligible distributions of earnings must fulfill two requirements. First, the seasoning period of five years since the opening of the Roth IRA account must have elapsed, and secondly a justification must exist such as retirement or disability. The simplest justification is reaching 59.5 years of age, at which point qualified withdrawals may be made in any amount on any schedule. Becoming disabled or being a "first time" home buyer can provide justification for limited qualified withdrawals. Finally, although one can take distributions from a Roth IRA under the substantially equal periodic payments rule without paying a 10% penalty, any interest earned in the IRA will be subject to tax—a substantial penalty which forfeits the primary tax benefits of the Roth IRA.Inherited Roth IRAs
When a spouse inherits a Roth IRA:- the spouse can combine the Roth IRA with his or her own Roth IRA
- the spouse can make contributions and otherwise control the account
- required minimum distributions do not apply
- income tax does not apply to distributions
- estate tax does not apply at the time of transfer
- the non-spouse cannot combine the Roth IRA with his or her own
- the non-spouse cannot make additional contributions
- required minimum distributions apply
- income tax does not apply to distributions, if the Roth IRA was established for at least five years before the distribution occurs.
- estate tax applies