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A Roth IRA is an individual retirement account that can provide you with tax-free income in retirement. With a Roth IRA, you save after-tax dollars and your money grows tax-free. Roth IRAs provide additional flexibility for withdrawals—once the account has been open for five years, contributions can be withdrawn at any time, for any reason.

How Does a Roth IRA Work?

A Roth IRA is a tax-advantaged account that holds investments to provide you with income in retirement. You contribute money to a Roth IRA from your earned income after you pay regular income taxes—unlike a traditional IRA, there is no upfront tax break with a Roth IRA. The tax benefits come later, as you pay no income tax on qualified withdrawals.

You can open a Roth IRA account at an online brokerage account, a bank or a credit union. If you choose an online broker, your Roth IRA funds can be used to purchase stock, bonds, mutual funds and exchange traded funds (ETFs). If you choose a credit union or a bank, you can place Roth contributions in a savings account or a certificate of deposit (CD).

You can withdraw contributions you’ve made to your Roth IRA penalty-free, for any reason, at any time. With a few exceptions, you’ll owe income taxes and penalties if you withdraw earnings within five years of having made your first contribution and before you turn age 59½. Once you turn 59½  and five years have elapsed since you made the first contribution to your Roth IRA, you may begin withdrawing earnings free of income taxes or penalties.

Who Is Eligible for a Roth IRA?

Only earned income—the IRS calls it “taxable compensation”—is eligible to be saved in a Roth IRA. That means you or your spouse need to have received income from employment or self-employment in order to save money in a Roth IRA in any given year. You cannot contribute passive or investment income—from interest, dividends or capital gains—to a Roth IRA.

Income thresholds limit who can contribute to a Roth IRA. As long as your modified adjusted gross income doesn’t exceed the income thresholds, you may contribute to a Roth IRA.

Roth IRA Contribution Limits

The annual contribution limit for a Roth IRA in 2020 and 2021 is $6,000, and savers who are 50 or older may contribute an additional $1,000.

Note that the annual contribution limit caps all of your IRA contributions: If you own a Roth IRA and a traditional IRA, or multiple IRAs of any kind, your total contributions to all accounts are limited to $6,000 for the year 2021, plus an additional $1,000 for savers 50 or older.

The annual income thresholds outlined in the table below limit who can contribute to a Roth IRA. Note that here are workarounds—see “Backdoor Roth IRA” section below.

Roth IRA Advantages

Here are a few of the key benefits of a Roth IRA:

  • You can withdraw your contributions at any time, for any reason, free of income taxes or penalties.
  • In certain situations, you can withdraw earnings early without paying penalties (e.g. for a first-time home purchase).
  • You pay no income taxes on qualified withdrawals from a Roth IRA in retirement.
  • Roth IRAs have no minimum contribution amount, which makes it easy to start saving (the bank or brokerage that holds your account may require a minimum investment).
  • You can contribute to a Roth IRA up until the tax-filing deadline. For example, you can make Roth contributions for 2020 until mid-April 2021.
  • Unlike traditional IRAs, there are almost never required minimum distributions for Roth IRAs.

Roth IRA Five-Year Rule

Five years is a key measure of time when you own a Roth IRA account. As noted above, contributions can be withdrawn from your Roth IRA at any time, for any reason. However, you need to wait five years after your first contribution in order to make penalty-free withdrawals of earnings from your Roth IRA account. The five-year clock starts ticking on January 1 of the year you first put money into your Roth IRA.

  • If you withdraw earnings before five years have passed, you may owe income taxes and a 10% penalty on the withdrawal.
  • You may owe income taxes and a 10% penalty if you withdraw money rolled over from a Traditional IRA or 401(k) into a Roth IRA before five years have passed.
  • If you inherit a Roth IRA from someone whose first Roth contribution was less than five years prior, you may owe income tax if you withdraw earnings.

Roth IRA Early Withdrawals

There are early withdrawal exceptions to the five-year rules outlined above. If fewer than five years have passed since you made your first Roth IRA contribution, you may withdraw earnings and avoid the 10% penalty for the following purposes (although you’ll still owe income taxes on the withdrawal):

  • Physical or mental disability
  • You’re buying your first home
  • You’ve given birth or adopted a baby
  • To pay for qualified medical expenses
  • To pay for health insurance while you’re unemployed
  • To pay for qualified higher education expenses
  • Taking substantially equal periodic payments
  • Paying an IRS levy
  • You’re withdrawing the money as a beneficiary
  • Qualified reservist distributions

If at least five years have passed since you made your first contribution to your Roth IRA account but you haven’t turned 59½ yet, earnings can be withdrawn free of income taxes and the 10% penalty for the following reasons:

  • Physical or mental disability
  • Up to $10,000 can be withdrawn to fund a first-time home purchase
  • You have died and the funds are withdrawn by a beneficiary

Roth vs. Traditional IRA: Which Do I Need?

If you are not covered by an employer-sponsored retirement plan, traditional IRA contributions reduce your taxable income, meaning a traditional IRA may be a better choice for your retirement savings.

If you are covered by an employer-sponsored retirement plan, there’s a relatively low income ceiling that would make you ineligible for the traditional IRA tax deduction. If your income is above this ceiling, you should consider a Roth IRA. Keep in mind, however, that your income must remain under the thresholds outlined above in order to be eligible for a Roth IRA.

What level of income makes you ineligible for the traditional IRA tax deduction in tax year 2020 if you’re covered by a workplace retirement plan? When filing taxes as single or head of household, the traditional IRA tax deduction begins to phase out when your modified adjusted gross income (MAGI) is more than $65,000, and is completely unavailable when your MAGI exceeds $75,000. When filing taxes jointly or you’re a qualified widower, the deduction starts phasing out when your MAGI is more than $104,000 and is not available for MAGI above $124,000.

There Are No Required Minimum Distributions (RMDs) for Roth IRAs

Traditional IRAs require you to begin taking out money from the account—called required minimum distributions (RMDs)—by April 1 of the year after you turn 72. With Roth IRAs, there are no required minimum distributions. You may leave the money completely untouched while you are alive and bequeath the Roth IRA account to your heirs, if you wish.

Note that new rules for Roth IRAs inherited in 2020 or later require that heirs withdraw funds from the account within 10 years, although there are exceptions for spouses and some other beneficiaries.

What Is a Backdoor Roth IRA?

A backdoor Roth IRA is a strategy available to people whose annual income would ordinarily disqualify them from making regular Roth IRA contributions. If your annual income exceeds the Roth IRA thresholds outlined above, a backdoor Roth IRA can give you access to the account. Here’s a basic view of how a backdoor Roth IRA conversion works:

•  Fund a nondeductible IRA. A nondeductible IRA is not a special variety of IRA, it’s simply a traditional IRA that you fund with after-tax contributions.

•  Open a Roth IRA account. Roll the funds from the nondeductible IRA account over into the Roth IRA.

•  You may owe income taxes on converted funds. If you hold no other funds in any IRA apart from nondeductible funds, you would only pay income tax on the earnings from your nondeductible IRA, if there are any. However, if you hold funds in an IRA that were made pre-tax (so-called deductible contributions), the pro-rata rule determines the amount of income tax owed on the backdoor Roth IRA rollover.

The pro rata rule works this way: Divide the total amount of nondeductible IRA contributions you’ve made by the sum of all IRA balances you hold—including both pre-tax, deductible contributions and post-tax, nondeductible contributions. Then multiply this figure by the amount you wish to rollover into the backdoor Roth IRA. The result is the amount on which you must pay income tax.

For example, consider a backdoor Roth IRA candidate who already holds $94,000 in a traditional IRA, comprising both pre-tax contributions and tax-deferred earnings. If they convert $6,000 in a new, nondeductible IRA via a backdoor Roth IRA, 94% of the $6,000 conversion would be taxable, because 94% of their combined IRA balance is pre-tax.

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