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Rules of the Game: Roth IRAs

Last week we talked about the Rules of Traditional IRAs. Today we are going to discuss Roth IRAs. As I said in last week’s article the main difference between the two is taxes. In Traditional IRAs you pay taxes later, in Roth IRAs you pay taxes now. In general, Roth IRAs are more popular because the earnings are tax free and they give you a little bit more flexibility if you need to withdraw some of your principal. But they aren’t for everyone. Like so many things in personal finance, they are just a tool.

Taxes

Roth IRAs are funded by after tax dollars. This means that you have already paid taxes on the money, you will not decrease your tax liability from funding your Roth IRA. Any money you make in the Roth IRA is tax free. You will never have to pay taxes on earnings. This means the balance in your Roth IRA is 100% available for spending. When you retire you will pay no taxes on your withdrawals.

There are two buckets of money inside your Roth IRA. In one bucket you have your contributions, which you paid income tax on. In another bucket you have your earnings, which you haven’t paid taxes on… and never will.

The bottom line: You will not owe any income taxes when you withdraw the money in retirement.

Contribution Limits

You can contribute up to $5,000 per year into your Roth IRA. These contributions must be made with earned income. This means money from a job. Passive income, such as stock dividends, cannot be used to fund Roth IRAs.

If you are over 50 years old you can contribute an additional $1,000 (for a total of $6,000) as a ‘catch-up’ contribution. There are no upper age limits on contributing to a Roth IRA.

The bottom line: From the time you start working until you turn 50 you can contribute $5,000. After age 50 you can contribute $6,000.

Income Limits

For those who file as single you can contribute the full $5,000 if you make under $107,000. If you make between $107,000 and $122,000 your contributions are phased-out, meaning you can contribute some, but not the full $5,000. How much you can contribute depends on how much you made. The closer you get to $122,000 the less you can contribute. If you make over $122,000 then you can’t contribute at all.

For those who file jointly you can contribute the full $5,000 if you make under $169,000. If you make between $169,000 and $179,000 your contributions are phased-out, meaning you can contribute some, but not the full $5,000. How much you can contribute depends on how much you made. The closer you get to $179,000 the less you can contribute. If you make over $179,000 then you can’t contribute at all.

The bottom line: If you file single and you make under $107,000 you can make a full contribution, if you earn over $122,000 you can’t make a contribution. If you file jointly and you earn under $169,000 you can make a full contribution, if you earn over $179,000 you can’t contribute.

Penalties

Penalties for early withdrawals are less severe in a Roth IRA than in a Traditional IRA. Remember how I said there were two buckets inside the Roth, one with your contributions in it (on which you have paid income taxes) and one with your earnings (on which you have not paid taxes on). If your Roth is over 5 years old you can take out your contribution bucket with no taxes or penalties. If you withdraw the earnings before you are 59.9 then you will owe income taxes as well as 10% penalty. While I don’t advocate taking money out of your retirement account, its good to know if you have an emergency.

The bottom line: If your Roth is over 5 years old you can take out the money you put in penalty free. If you dip into your earnings you will owe income taxes and a 10% penalty.

2 thoughts on “Rules of the Game: Roth IRAs”

  1. The more and more I read about a Roth it seems the way to go. I expect within a few years, even including my MAGI after 401k contributions, I will probably still be over the income limit…is it worth it to invest in a Roth even if only for 2 or 3 years? Or go another route?

  2. If you were to put $15,000 in a Roth and it earns 10% for 30 years you would have nearly $300,000. The trick is if you are really going to pay extra to a Traditional IRA because you don’t have to pay taxes on it… Let’s say that to get $15,000 after taxes you would have to earn $20,000. If you put that whole $20,000 into the same investment scenerio you would have nearly $400,000 but would owe taxes on the whole thing. So assuming the same tax rate in retirement it really wouldn’t matter.

    If your taxes are lower in retirement you do better with the traditional, if your taxes are higher in retirement you do better with a Roth. but only if you are disciplined enough to really make sure you are investing any tax break you get from the traditional IRA. It’s my belief that few people actually do that. They get the tax break and spend it on other things.

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