A Roth IRA is a special type of individual retirement plan. It is subject to many of the same rules that apply to traditional individual retirement arrangements (IRAs). But there are some differences in the tax treatment of contributions and distributions. One of these differences is that unlike a traditional IRA, you cannot deduct contributions to a Roth IRA. But if you satisfy certain requirements, qualified distributions from a Roth IRA are tax-free.
The main tax advantage of a Roth IRA is that even though your contributions are not tax-deductible and are not reported on your tax return, your earnings can accumulate tax-free and qualified withdrawals are generally not taxable and can be made without a penalty.
Who Can Set Up and Contribute to a Roth IRA?
You can set up a Roth IRA regardless of your age. It must be designated as a Roth IRA when you set it up. In order to contribute to a Roth IRA, you must have taxable compensation and your modified adjusted gross income must be less than a certain maximum amount, defined based on your tax filing status. There is a phase-out of the contribution for modified adjusted gross income over a certain amount up to a maximum ceiling. Above the ceiling, contributions cannot be made. The amount you can contribute, subject to the maximums, is higher if you are age 50 or older. You can continue to make contributions to a Roth IRA after you reach 70 ½, and you do not have to make required withdrawals – you can leave amounts in your Roth IRA as long as you live.
Taxable Compensation
Taxable compensation for these purposes includes wages, salaries, tips, professional fees, bonuses, commissions, and other income received for providing personal services. Taxable compensation also includes self-employment income and alimony and separate maintenance payments.
Limits Based on Modified Adjusted Gross Income
The limits on modified adjusted gross income, and the amounts that can be contributed to a Roth IRA according to those limits, are published by the Internal Revenue Service (IRS) and can be found in IRS Publication 590, Individual Retirement Arrangements (IRAs). The limit is highest for taxpayers who are married filing jointly or as a qualifying widow(er), and is lower for taxpayers filing as single or head of household, and taxpayers who are married filing separately but who did not live with their spouse. Taxpayers who are married filing separately and who lived with their spouse have the lowest limit on modified adjusted gross income.
What Is Modified Adjusted Gross Income?
Modified adjusted gross income for Roth IRA purposes is adjusted gross income as reported on your tax return, with certain modifications. From your adjusted gross income you subtract any income resulting from the conversion of another IRA to a Roth IRA, and then add back certain adjustments to income, including a deduction for contributions to a traditional IRA, the student loan interest deduction and tuition and fees deduction, any foreign earned income exclusion and foreign housing exclusion or deduction (Form 2555), the exclusion of qualified bond interest (Form 8815), and the exclusion of adoption benefits provided by your employer (Form 8839).
Amount of Contributions
The amount you can contribute to a Roth IRA depends on the limits on modified adjusted gross income, as described above, and also depends on whether you are making contributions only to a Roth IRA or to both a Roth IRA and a traditional IRA. If you make contributions to both, your contribution to your Roth IRA is limited to the lesser of:
The limit for Roth IRAs, based on your modified adjusted gross income and filing status, minus all amounts you contribute to IRAs other than Roth IRAs, or
Your taxable compensation minus all contributions to IRAs that are not Roth IRAs.
Contributions your employer makes to a SEP or SIMPLE IRA plan are not taken into consideration in calculating this limitation on your Roth IRA contributions.
There are worksheets in IRS Publication 590 that will help you calculate the amount you can contribute when you are subject to a limitation because you have contributions to other types of IRAs, or because your modified adjusted gross income is over the amount allowable for the maximum contribution, but is still within the range allowable for phase-out of the contribution (less than the ceiling amount).
If You Contribute Too Much
There is a 6% excise tax on excess contributions. Excess contributions include the total of the amount by which your current year contributions exceeded the applicable limits, as described above (maximum contribution according to filing status and modified adjusted gross income, less contributions to other IRAs), plus any excess contributions from the preceding year, reduced by any distributions you received from your Roth IRA during the year, and also reduced by your contribution limit for the year less contributions to other IRAs.
If you contribute more than the allowable amount to your Roth IRA one year, you can apply the excess contributions to a later year, when your contributions are less than the maximum allowable.
Excess contributions do not include amounts that are properly rolled over from a Roth IRA or converted from a traditional IRA.
Conversions
There are three different ways you can convert, or roll over amounts from a traditional IRA to a Roth IRA:
You can take a distribution from a traditional IRA and roll it over into a Roth IRA within 60 days.
You can have the trustee of your traditional IRA transfer an amount to the trustee of your Roth IRA.
If the same trustee maintains both your traditional IRA and your Roth IRA, you can have the trustee make a transfer.
Recharacterization
A contribution that was originally made to another type of IRA, such as a traditional IRA, can be “recharacterized”, or treated as if it had been made to a Roth IRA. In order to recharacterize a contribution, it must generally be through a trustee-to-trustee transfer. If you recharacterize a contribution, you must:
Include in the transfer any income earned on the original contribution.
Report the recharacterization on your tax return.
Treat the contribution as having been made to your Roth IRA on the date it was actually made to the first IRA.
Failed Conversion
If when you made the conversion, you expected that your modified adjusted gross income for the year would not be over the limit, and that your filing status would not be married filing separately (the lowest limit), but your situation did not turn out as you had expected, you may have what the IRS refers to as a “failed conversion”. This means that:
You will have to pay the 6% excise tax on any excess contribution that is not withdrawn from your Roth IRA,
The distributions from your traditional IRA will have to be included in your gross income, and
The 10% additional tax on early distributions from your traditional IRA may apply.
In order to avoid these consequences, you would have to move the amount you converted, plus any earnings on that amount, back into a traditional IRA before the due date for filing your tax return. In this case, you would not have to include the distribution in your income.
Distributions
Qualified distributions from your Roth IRA are not included in your taxable gross income. To be qualified, a distribution has to meet the following requirements:
It has been at least 5 years since the beginning of the first year you set up and contributed to the Roth IRA.
You must have made the distribution:
On or after the date you reached age 59 ½,
Because you are disabled,
To a beneficiary or to your estate after your death, or
To buy or rebuild a first home.
Additional Tax on Early Distributions
A distribution that does not qualify according to these conditions may be subject to a 10% additional tax as an early distribution. If you convert amounts from another IRA, such as a traditional IRA, to your Roth IRA, a separate 5-year period applies to each conversion. You generally have to pay the 10% additional tax on any part of a conversion that you had to include in income. The 10% additional tax applies in the year of the distribution. There are “ordering rules” to determine how much of a distribution has to be included in taxable income (see below).
Normally, you would have to pay the 10% additional tax on the part of any distributions that must be included in your income because they are not “qualified distributions”, as defined above. But there are exceptions. You may not have to pay the additional tax if you have not yet met the 5-year test, but you are 59 ½ years of age or older, you are disabled, the distribution is made as a result of your death, or the distribution is used to buy or rebuild a new home (the tests for qualified distributions, other than the 5-year period test). Other exceptions include:
The distributions are part of a series of substantially equal payments (such as an annuity).
You have significant un-reimbursed medical expenses, or you are paying medical insurance premiums after losing your job.
The distribution is being used to pay qualified higher education expenses.
The distribution is due to a levy by the IRS.
Ordering Rules
In determining how much of an unqualified distribution is taxable, distributions are considered to have been made in a certain order, as follows:
Regular contributions are considered to have been distributed first.
Conversion contributions are next, on a first-in-first-out basis (the earliest conversions are considered as distributed first). The taxable part of the conversions (the amounts that had to be included in income at the time of conversion) is considered first, followed by the non-taxable portion.
Earnings on contributions are considered as distributed last.
Calculating Taxable Part of an Unqualified Distribution
There is a worksheet in Publication 590 that guides you through the calculation to determine the taxable part of any unqualified distribution. For purposes of this calculation, contributions and distributions are grouped together. This calculation is summarized as follows:
Total of all distributions from your Roth IRAs during the year
Minus qualified distributions during the year
Minus distributions made during the year to correct excess contributions during the year
Minus distributions that were contributed to another Roth IRA in a qualified rollover
This result is them compared to the result of the following calculation:
Total of all prior distributions from your Roth IRAs, whether or not they were qualified
Plus distributions from your Roth IRAs during the year
Minus distributions that were previously included in your taxable income
Minus the total of all your contributions to all your Roth IRAs, less total distributions made to correct excess contributions (this year and in prior years)
This result is then compared with the first, and the smaller of the two is the taxable part of your distribution.
Are There Any Required Distributions or Withdrawals?
The distribution rules that apply to traditional IRAs do not apply to Roth IRAs. With a Roth IRA you are not required to make withdrawals at any age, as long as you live. However, in the event of the death of a Roth IRA owner, there are minimum distribution rules that apply. These are generally the same as those that would apply for traditional IRAs.
Distribution to a Beneficiary
The entire amount in the Roth IRA must be distributed within 5 years after the end of the year of the owner’s death, unless the amount in the Roth IRA is payable as an annuity to a designated beneficiary. The entire amount must be payable over no longer than the beneficiary’s life expectancy, and distributions must begin during the calendar year following the owner’s death. If the beneficiary is the owner’s spouse, the distributions can be delayed until the decedent would have reached age 70 ½.
If the distribution is not a qualified distribution, because the 5-year period had not been completed by the date of the owner’s death, for example, the distribution may be taxable to the beneficiary. But the additional 10% tax would not apply because of the exception for the death of the Roth IRA owner.
Tax on Excess Accumulations
If the required minimum distributions are not made from an inherited Roth IRA, or if the distributions are less than the required amounts, there may be a 50% excise tax applied on the amount that was not distributed as required.
Main Differences Between a Roth IRA and a Traditional IRA
Contributions to a Roth IRA are never deductible. Your contribution to a traditional IRA may be deductible if you qualify.
Contributions cannot be made to a traditional IRA for the year in which you reach age 70 ½ or for any later year, but there is no age limit for contributing to a Roth IRA.
No federal income tax is paid on qualified withdrawals of earnings from a Roth IRA. Federal income tax is always paid on withdrawals of earnings, as well as deductible contributions, from a traditional IRA.
With a Roth IRA, you have the flexibility to withdraw contributions at an earlier age than you do with a traditional IRA, but you are not obligated to make withdrawals at any age.