A Roth Individual Retirement Account (IRA) account is a tax-advantaged retirement account where workers can save money for their retirement. Unlike traditional IRAs, Roth IRA contributions are not tax-deductible, but the earnings grow tax-free and qualified distributions are also tax-free. There are no required minimum distributions, since taxes have already been paid on the money.
However, there is a 5-year holding period after the creation of the 1st Roth IRA, which includes the year when the Roth IRA was set up, before earnings can be withdrawn tax-free, even if the distributions would otherwise be qualified. However, once the 5-year holding period is satisfied for one Roth IRA account, then this requirement does not apply to any other Roth IRAs. In other words, a new Roth IRA account can be set up and earnings can be withdrawn tax-free at any time as long as the 5-year holding period has been met by any of the taxpayer's Roth IRA accounts. If this 5-year rule is violated, then the earnings, but not the contributions, are taxable, but the earnings are not subject to a 10% withdrawal penalty if the distribution would otherwise be qualified.
Low-income taxpayers may be able to claim a credit for contributions made to a Roth IRA, where the taxpayer can receive a credit of up to 50% of any contribution up to $2000. Therefore, the maximum credit is $1000.
Roth IRAs can be either an account or an annuity, but certain other employer-provided retirement accounts can also qualify as deemed IRAs. After 2002, an employer can have a qualified retirement plan maintained as a separate account or annuity to receive voluntary employee contributions — what is called a deemed IRA. Such plans will be subject only to IRA rules if they otherwise meet IRA requirements. Such plans can be treated as either traditional or Roth IRA's. A qualified employer plan includes:
- pension, profit sharing, stock bonus, or other §401(a) plan;
- qualified employee annuity §403(a) plan;
- tax-sheltered annuity §403(b) plan; or
- a deferred compensation §457 plan, that is maintained by the state or any political subdivision or agency thereof.
Designated Roth accounts are separate accounts that are set up under §§401(k), 403(b), or 457(b) for taxpayers to make taxable contributions, called Roth contributions. Distributions are tax-free. However, in spite of the similarities with IRAs, designated Roth accounts are not IRA accounts.
The Secure Act 2.0, passed at the end of 2022, makes it easier for employers to help workers open emergency savings accounts, assist employees who are repaying student loan debt and allow part-time workers access to retirement plans in 2 years instead of 3. There are also new benefits to both Roth IRAs and Roth 401(k)s, including moving leftover money from a 529 college savings account to a Roth I.R.A. Certain rules must be followed to avoid taxes and penalties, and there are some income restrictions. However, some provisions start in different tax years.
Secure Act 2.0 changes for Roth IRAs:
Starting in 2024:
- The catch-up contribution for IRAs will be adjusted annually for inflation in increments of $100.
- Unused funds in a 529 college savings account may be rolled over to a Roth IRA.
- There is a $35,000 lifetime limit on these transfers per account beneficiary and other restrictions to lower the benefit for affluent taxpayers.
- The rollover must be a direct trustee to trustee transfer from the 529 plan to the Roth IRA.
- The 529 plan account must exist at least 15 years before transfers can be made.
- Contributions and earnings from those contributions from the previous 5 years cannot be transferred.
- Annual IRA contribution limits apply for the beneficiary, so the contributions by the beneficiary to a traditional IRA or a Roth IRA plus the amount rolled over cannot exceed the annual limits.
- However, the annual AGI limit for Roth IRA contributions does not apply to the transfer from the 529 plan to the Roth IRA.
Secure Act 2.0 changes for IRAs:
- Increases the required minimum distribution (RMD) age from 72:
- to 73 in 2023
- to 75 in 2033
- The penalty for not taking an RMD on time has been reduced from 50% of the amount that should have been withdrawn to 25%, and to 10% for IRAs if corrected.
Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 (SECURE Act) has changed the law regarding qualified tax-deferred retirement accounts:
- beneficiaries of tax-deferred retirement plans must receive the full distribution within 10 years after the death of the employee or account holder;
- the age limit to make contributions to a traditional IRA has been repealed (previously 70½), starting with contributions for tax year 2020 and thereafter;
- the age for starting required minimum distributions has been increased from 70½ to 72;
- up to $5000 of distributions from retirement plans can be penalty-free if used to pay for expenses of a birth or an adoption; and
- pension and benefit plan administrators must disclose the plan's lifetime income stream to the beneficiaries;
- for graduate or postdoctoral students, taxable non-tuition fellowship and stipend payments may be treated as compensation to allow more IRA contributions for tax years after 2019.
The money in a Roth IRA account consists of contributions and earnings. Contributions consist of money or property contributed to the account and serve as the tax basis of the account.
Unlike traditional IRAs, there is no age limit for contributions. Contributions can be made by the due date of the return for a given tax year, not including extensions. A taxpayer can contribute to the Roth IRA of a spouse if the couple files jointly.
Annual contributions are limited to the lesser of taxable compensation or these statutory limits:
|Year||Age < 50||Age ≥ 50|
|2019 - 2022||$6,000||$7,000|
|2013 - 2018||$5,500||$6,500|
Contributions can be made both to Roth and traditional IRAs. However the applicable limits apply to the total of contributions to both accounts. However, employer contributions under a SEP or SIMPLE IRA are not counted.
Taxable compensation includes any type of compensation for work but also includes taxable alimony or separate maintenance payments. It does not include investment income or inheritance. Contributions may be limited for upper income taxpayers if their modified adjusted gross income (MAGI) exceeds certain amounts, depending on filing status.
|Married filing jointly or separately or qualifying surviving spouse (QSS).||$218,000||$204,000||$198,000|
|Source: COLA Increases for Dollar Limitations on Benefits and Contributions | Internal Revenue Service|
There are different MAGI limits for deducting contributions for those taxpayers or their spouses covered by an employer retirement plan:
|Married filing jointly or qualifying surviving spouse (QSS)||$109,000||$105,000|
|Married filing separately||0||0|
|All others, including married filing separately |
for spouses who did not live together
at any time during the tax year.
|Source: COLA Increases for Dollar Limitations on Benefits and Contributions | Internal Revenue Service|
- Note that these limits apply if the taxpayer is eligible for an employer plan, even if the taxpayer chooses not to participate in the plan.
- Likewise, a nonparticipating spouse must be ineligible for the other spouse's employer's plan
for these limits to apply.
- Source: Cost-of-Living Adjustments for Retirement Items
If the taxpayer's income exceeds the phaseout limit, then the taxpayer cannot make contributions to an IRA. MAGI, in regard to Roth IRAs, equals: AGI minus Roth IRA conversions or rollovers plus the following deductions and exclusions:
- traditional IRA deduction,
- student loan interest deduction,
- tuition and fees deduction,
- domestic production activities deduction,
- foreign earned income exclusion,
- foreign housing exclusion or deduction,
- exclusion of qualified bond interest, reported on Form 8815, plus
- exclusion of employer-provided adoption benefits, reported on Form 8839, Qualified Adoption Expenses.
To calculate the reduced Roth IRA contribution limit:
- Subtract the MAGI threshold from the MAGI.
- Divide by the phaseout range, which is $10,000 for joint filing, qualifying surviving spouse (QSS), or married filing separately, where the taxpayer lived with the spouse at any time during the year. For all others, $15,000.
- Divide the amount of MAGI over the threshold amount by the phaseout range and round to 3 decimal places.
- Multiply the contribution limit by the amount of the above fraction.
- Subtract that amount from the applicable contribution limits.
- Round the results to the nearest $10; if less than $200 but exceeding 0 then enter $200; otherwise enter 0.
Subtract contributions made to other IRAs from the contribution limit for the year, then enter the lesser of the amounts just calculated.
|MAGI of 45-year-old Single Taxpayer||$123,000|
|Maximum Contribution Limit||$5,000|
|Excess of MAGI over Threshold||$13,000||= MAGI − Phaseout Threshold|
|Phaseout Range||$15,000||= Phaseout Limit − Phaseout Threshold|
|Contribution Reduction Factor||0.867||= Rounded to 3 Decimal Places (Excess MAGI / Phaseout Range)|
|Contribution Reduction||$4,333||= Contribution Limit × Contribution Reduction Factor|
|Contribution Limit for MAGI ($667 rounded to $670.)||$670||= Rounded to Nearest $10 (Contribution Limit − Contribution Reduction)|
Sometimes a taxpayer will contribute too much to an IRA account because of miscounting the contributions made during the year, because they exceeded taxable compensation, or because the taxpayer earned too much, reducing the amount that can be contributed. Excess contributions are penalized with a 6% excise tax on the excess amount, which equals:
Excess Contribution Penalty = (Excess Contributions for Tax Year + Proceeding Year × [Excess Contributions − (Distributions + Contribution Limit − Contributions to all IRAs)]) × 6%
The excise tax can be avoided if the excess contribution plus associated earnings are withdrawn by the due date of the tax return. Earnings are attributed to the tax year of the excess contribution. If the taxpayer fails to withdraw the excess contributions and earnings, then the excise tax can still be avoided if an amended return is filed within 6 months of the due date, not including extensions, with a statement "Filed pursuant to section 301.9100-2" written at the top. Excess contributions can also be reallocated to a later tax year if the contributions for that year are less than the contribution limit minus the reallocated excess contributions.
Rollovers and Conversions
A rollover occurs when a distribution from one type of retirement account is contributed to a different type of retirement account. A conversion occurs when money is transferred between the trustees of different accounts or between different accounts managed by the same trustee or if the account is simply recharacterized as a different type of account. More than 1 rollover or conversion per year is not permitted.
Amounts held in a traditional, SEP, or SIMPLE IRA can be converted into a Roth IRA, or money can be rolled over from a qualified retirement plan to a Roth IRA or contributions to different IRA accounts can be re-characterized as being made to a Roth IRA. Moreover, amounts can be rolled over from a designated Roth account or between different Roth IRA accounts.
There are several methods to convert money held in a traditional IRA to a Roth IRA:
- the money can be received as a distribution and contributed to a Roth IRA within 60 days after the distribution;
- the trustee of the traditional IRA can be directed to transfer money to the trustee of the Roth IRA;
- if both IRAs have the same trustee, then the trustee can be directed to transfer money from the traditional to the Roth IRA or the trustee can be directed to simply recharacterize the traditional IRA as a Roth IRA, thus avoiding opening any new accounts or signing new contracts.
Since most contributions to a traditional IRA are tax deductible, any amounts rolled over or converted to a Roth IRA must be included in income for the year of the rollover or conversion. If some of the contributions to the traditional IRA were nondeductible, then the taxable amount of a transfer is determined thus:
Taxable Portion of Rollover or Conversion = Amount Transferred × Deductible Contributions / Total Contributions of All Traditional IRA Accounts
If the taxpayer is younger than 59½, then any tax due on the transfer should be paid by the taxpayer rather than having it deducted from the transfer, since, in such a case, a 10% tax penalty will be applied to the amount of the tax that was deducted as a penalized early withdrawal. Note also, that a 10% penalty will also apply to any amounts withdrawn within 5 years of the conversion, and the 5 years is counted from the most recent conversion. The 5-year rule for Roth IRAs was implemented to prevent taxpayers from using a conversion or rollover to evade the 10% early distribution penalty that would have applied if the distribution was taken directly from a tax-deferred account.
Example: Calculating the 10% Early Distribution Penalty for Withdrawals from a Roth IRA
- A taxpayer younger than 59½ converts $10,000 from a traditional IRA to a Roth IRA.
- She pays taxes on the converted amount for that year.
- The next year she withdraws all the money, $10,300, including $300 of earnings, from the Roth IRA.
- She must pay tax on the $300 of earnings, but, unless the distribution was qualified in some other way, she also must pay the 10% early distribution penalty on the entire amount, = $1030, because the rolled over amount was not held for at least 5 years after the 1st day of the year of the contribution.
- Total tax liability = $1030 + $300 = $1330
If the taxpayer is older than 72, who is subject to a required minimum distribution (RMD), then the RMD must still be taken, since the transfer does not count as an RMD.
Any conversions must be completed by December 31, but the taxpayer can revert, or undo, the conversion by the tax filing date for that year, including extensions, if the taxpayer decided that the conversion was not a smart tax decision.
- If your tax credits, deductions, or exemptions exceed your taxable income for any given tax year, then you can avoid additional taxes by transferring only the amount equal to the difference between the amount of income that would become taxable and your income without the transfer.
- So if you had $20,000 worth of tax deductions, but only $16,000 of taxable income, then you would be able to transfer $4000 from a tax-deferred account to a Roth account tax-free, which could then grow tax-free and would remain tax-free when withdrawn.
- Additionally, if your traditional IRA holds any after-tax contributions, then IRS Notice 2014-54 allows you to direct the after-tax contributions to a Roth IRA, thereby simplifying the calculation of taxable income on distributions from the traditional IRA.
Rollover from an Employer's Plan into a Roth IRA
A distribution received from an employer's plan can also be rolled over into a Roth IRA, if the plan is one of the following types:
- employers qualified pension, profit sharing, or stock bonus, 401(k) plan;
- annuity plan;
- tax-sheltered §403(b) annuity plan;
- or a government deferred compensation §457 plan.
Any distribution from a qualified retirement plan must be rolled over to a Roth IRA within 60 days. However, 20% of the distribution will be withheld by the payer, as required by tax law. There is also a direct rollover option, where if an employer's qualified plan allows it, a rollover distribution can be paid directly to a Roth IRA without having any tax withheld from the distribution.
Naturally, any contributions that were tax-free that are rolled over into a Roth IRA will be includable as income in the year of the rollover or conversion. In such a case, withholding or estimated tax payments may have to be increased.
Military death gratuity or Servicemembers' Group Life Insurance (SGLI) payments received because of a death from an injury that occurred after October 6, 2001, can be rolled over to a Roth IRA without regard to the 1 year waiting period that generally applies to successive rollovers, but the rollover must be completed within 1 year of receiving the distribution. The entire distribution can be rolled over minus any contribution to another Roth IRA or by any contribution to a Coverdell ESA.
Any income received because of the Exxon Valdez settlement can also be rolled over into a Roth IRA, but the income is subject to taxes in the year in which it is received. Special rules, not discussed here, also apply to the rollover of airline payments received by qualified airline employees.
Recharacterization and Reconversions of Roth Rollovers and Conversions
A contribution or rollover to a traditional IRA can be recharacterized as a contribution to a Roth IRA. Previously, the taxpayer could change their mind about the recharacterization, but this is no longer allowed.
Roth Conversion Recharacterizations Are Eliminated by New Tax Law
Starting in 2018, under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, a Roth conversion recharacterizations cannot undo a Roth conversion. However, a contribution to a Roth IRA can be recharacterized as a contribution to a traditional IRA if done before the due date of the tax return. Also, a traditional IRA can still be converted to a Roth IRA.
Tax tip: If your income is too high to contribute to a Roth IRA, then a tax loophole can be used to circumvent that limitation — by contributing to what is called a backdoor Roth IRA. If you have a traditional IRA that has nondeductible contributions and if your employer has a 401(k) plan that allows it, you can transfer the deductible portion of the IRA to the 401(k), then transfer the nondeductible portion from the traditional IRA to the Roth IRA. If you cannot use the above strategy, then a variation of this strategy is to make nondeductible contributions to a traditional IRA, which has no income limits, then immediately converting it to a Roth IRA, which will allow the amount to grow tax-free. Distributions will also be tax-free.
Qualified distributions from a Roth IRA are not taxable. A qualified distribution is any distribution from a Roth IRA that meets the following requirements: the distribution occurs after a 5-year period that begins with the 1st tax year for which a contribution was reported, or if any part of the distribution is allocable to a rollover or conversion, then the 5-year waiting period begins on the date of the distribution or conversion; and the distribution was paid to a taxpayer who is at least 59½ or because the taxpayer became disabled or died, and the distribution was paid either to the estate or to a beneficiary, or the distribution satisfies the requirements for using the distribution to purchase a 1st home.
10% Tax Penalty on Early Distributions
Most distributions not qualified are considered early distributions, where the earnings portion of the distribution is subject to both ordinary income taxes and an additional 10% tax penalty. Any distribution from a Roth IRA is considered 1st to come from contributions, which is not taxable since the contributions were made with after-tax income and it is not subject to the 10% tax penalty. The tax basis of the Roth IRA, however, is reduced by any distribution allocable to contributions. After the basis has been reduced to 0, any remaining distributions are considered earnings, which is includable as income and subject to the 10% tax penalty. So if a taxpayer receives an early distribution of $5000, with a tax basis of $4000, then the $4000 is not includable as income nor is it subject to a 10% tax penalty; however, the $1000 earnings portion is both includable as income and subject to the 10% tax penalty of $100.
Any contributions later withdrawn before the due date of the return, including extensions, are considered to have never been made, so they are not subject to any tax penalties. So any excess contributions that were later withdrawn before the due date of the return will not be subject to the 6% excise tax. However, any earnings associated with the excess contribution must also be withdrawn and will be subject to the 10% tax penalty. (Note, however, that any contributions must be made by the due date, not including extensions.) So if you contributed $1000 too much for a given tax year and earned $60 on the amount, then to avoid the 6% tax penalty, withdraw $1060, include the $60 as income on Form 1040, and pay the 10% tax penalty of $6 on the earnings on Form 1040.
An early distribution is any distribution that does not satisfy the requirements of a qualified distribution. Besides the exceptions already noted in the definition for qualified distributions, there are several more exceptions in which the 10% tax penalty will not have to be paid:
- the distributions were used to pay either unreimbursed medical expenses that exceed 10% of the taxpayer's adjusted gross income or medical insurance premiums while the taxpayer was unemployed;
- the distribution was used to pay for qualified higher educational expenses of spouse, children or grandchildren;
- the IRS levied money out of the account because of unpaid taxes; or
- the distribution is a qualified reservist distribution.
Distributions for qualified reservist and qualified disaster recovery assistance can be repaid even if the total contributions to a Roth IRA exceed the general limit. However, the total payments cannot exceed the distribution amount. Repayments of reservist distributions increase the basis of the Roth IRA by the amount of the repayment. However any repayments of qualified disaster recovery assistance distributions are 1st considered a repayment of earnings, with any remaining portion increasing basis.
Distribution Ordering Rules
To determine the taxable portion of any early distribution, the source of the distribution is attributed in the following order:
- regular contributions;
- conversion and rollover contributions, on a first-in, first-out basis, in which any taxable portion that must be included as income is reduced 1st before any nontaxable portion;
- earnings on contributions.
The taxable portion of a nonqualified distribution is calculated in Part III, Distributions from Roth IRA's of Form 8606, Nondeductible IRAs:
- To calculate the 10% tax penalty on a nonqualified distribution, the Roth IRA basis is subtracted from the nonqualified distributions made during the year. If the Roth IRA basis exceeds the nonqualified distributions, then there is no 10% tax penalty. Any remainder is subject to the 10% tax penalty, which is figured in Part I on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax Favored Accounts.
- The next step is to subtract any basis in conversions from traditional, SEP, and SIMPLE IRAs, and rollovers from qualified retirement plans. The remainder is added to taxable income in the Income section of 1040.
Recognizing Investment Losses
Losses on a Roth IRA will only be recognized when the total amount from all Roth IRA's for a given taxpayer is distributed and the distribution is less than the basis in the Roth IRA's, which is the total amount of contributions to all Roth IRA accounts. Previous to the 2017 Tax Cuts and Jobs Act (TCJA), losses were deductible as a miscellaneous itemized deduction subject to the 2% of adjusted gross income limit, calculated on Schedule A, Itemized Deductions of Form 1040, but the 2017 TCJA eliminated this deduction.
If a Roth IRA owner dies, then the amounts in the Roth IRA accounts must be distributed to beneficiaries. If distributed as a lump sum, then it must be distributed before the end of the 5th calendar year postmortem. If paid as an annuity, then the amount of each distribution cannot be less than the amount that would be necessary to pay the beneficiary over his expected lifetime, as determined in IRS tables, in which case, distributions must begin before the end of the calendar year after the year of death. However, if the beneficiary is a surviving spouse, then the spouse can elect to receive distributions when the decedent spouse would have reached 72 or the surviving spouse can simply treat the IRA account as her own.
Failure to take the required minimum distribution (RMD) may result in a 50% excise tax on the amount that was not distributed, but should have been:
Insufficient RMD Tax Penalty = (RMD − Amount Distributed) × 50%
Distributions to beneficiaries that are not qualified distributions, because the Roth IRA owner died before satisfying the 5-year rule for qualified distributions, must include allocated earnings from the distributions as taxable income. Generally, basis, earnings, and any portions allocated to a rollover or conversion are divided proportionately among beneficiaries.
Example. How Nonqualified Distributions from a Roth IRA to Beneficiaries Is Taxed
- A taxpayer dies in 2012 after having made regular contributions of $6,000 in 2009 and also had $9,000 converted in 2010.
- The account earned $1,200.
- No distributions were made prior to his death.
- He named his 3 children as equal beneficiaries and each received an immediate distribution of $5400.
- Therefore, each child is allocated a basis of $2000, $3000 from the conversions, and $400 in earnings, so each child must include the $400 in earnings as income.
- However, the 10% tax penalty does not apply because the distributions were made after the death of the IRA owner.