Overview
A Roth IRA can be an individual retirement account containing investments in securities, usually common stocks and bonds, often through mutual funds (although other investments, including derivatives, notes, certificates of deposit, and real estate are possible). 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 (or the place where the plan is established). The total contributions allowed per year to all IRAs is the lesser of one's taxable compensation (which is not the same as adjusted gross income) and the limit amounts as seen below (this total may be split up between any number of traditional and Roth IRAs. In the case of a married couple, each spouse may contribute the amount listed):History
Originally called an "IRA Plus", the idea was proposed by SenatorDifferences from a traditional IRA
In contrast to aAdvantages
* Direct contributions to a Roth IRA (principal) may be withdrawn tax and penalty-free at any time. Earnings may be withdrawn tax and penalty-free after 5 years if the condition of age 59½ (or other qualifying condition) is also met. Rollover, converted (before age 59½) contributions held in a Roth IRA may be withdrawn tax and penalty-free after 5 years.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 (tax-free) 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(k). (Contributions may be made to a traditional IRA in this circumstance, but they may not be tax deductible.) * 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 relatedDisadvantages
* 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 (within income limits). 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 (such as a 401(k), 403(b), Simple IRA or SEP IRA) 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 (AGI). By contrast, contributions to a traditional IRA or most employer sponsored retirement plans reduce AGI. Reducing one's AGI has a benefit (besides reducing taxable income) 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. (A lower tax rate can also occur if Congress lowers income tax rates before retirement.) 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 tax and who contributes to a Roth IRA (instead of a traditional IRA or a tax deductible employer sponsored retirement plan) 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. (To benefit from this exemption, the beneficiary must be named in the appropriate IRA beneficiary form. A beneficiary inheriting the IRA solely through a will is not eligible for the estate tax exemption. Additionally, the beneficiary will be subject to income tax unless the inheritance is a Roth IRA.) Heirs will have to pay taxes on withdrawals from traditional IRA assets they inherit, and must continue to take mandatory distributions (although they will be based on their life expectancy). 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 Contracts 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
Double taxation may still occur within these tax sheltered investment plans. For example, foreign dividends may be taxed at their point of origin, and the IRS does not recognize this tax as a creditable deduction. There is some controversy over whether this violates existing Joint Tax Treaties, such as the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital. For Canadians with U.S. Roth IRAs: A 2008 rule provides that Roth IRAs (as defined in section 408A of the U.S. Internal Revenue Code) and similar plans are considered to be pensions. Accordingly, distributions from a Roth IRA (as well as other similar plans) 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 (other than rollover contributions from another Roth IRA), 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 (essentially a savings account) 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 theirContribution 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 convertBackdoor contributions
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 make Roth IRA contributions even if their income is above the limits. 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. In effect, one cannot choose the tax character of the contribution, as it must reflect the existing proportion of tax character in traditional IRAs. For example, a traditional IRA contains $10,000 post-tax and $30,000 pre-tax funds, it has 75% pre-tax character. Converting $10,000 into a Roth would lead to 75% ($7,500) of the contribution being considered taxable. The pro-rata calculation is made based on all traditional IRA contributions across all the individual's traditional IRA accounts (even if they are in different institutions). Backdoor Roth IRA contributions were explicitly allowed by the Tax Cuts and Jobs Act of 2017. Prior to that, there was concern that the process would violate the step transaction doctrine that one cannot combine individually legal steps to achieve an outcome that would be illegal if done in a single step.Distributions
Returns of regular contributions from Roth IRA(s) are always withdrawn tax and penalty-free. Eligible (tax and penalty-free) 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 (SEPP) 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 (if any) does not apply at the time of transfer When a non-spouse inherits a Roth IRA: * 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.See also
*References
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