Roth IRAs

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. A primary advantage of Roth IRAs is that contributions, but not earnings, can be withdrawn at any time without penalty, even if the taxpayer is younger than 59½, and any amounts withdrawn are considered to be from contributions 1^st. So, withdrawing any amount that is less than the total contributions is always both tax-free and penalty free!

However, there is a 5-year holding period after the creation of the 1^st Roth IRA, including the year when the Roth IRA was set up, before earnings can be withdrawn tax-free, even if the distributions would otherwise be qualified. More on this later.

Low-income taxpayers may claim a credit for contributions to a Roth IRA, to receive a credit of up to 50% of a contribution of up to $2000, for a maximum credit of $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 — 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 maintained by the state or any political subdivision or agency thereof.

Designated Roth accounts are separate accounts set up under §§401(k), 403(b), or 457(b) plans, or since 2023, under SEP IRAs or SIMPLE IRAs, for taxpayers to make taxable contributions, called Roth contributions. Distributions are tax-free and there are no required minimum distributions for these accounts.

Contributions

The money in a Roth IRA account consists of contributions and earnings. Contributions are the money 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. Taxpayers aged 50+ can contribute at least an additional $1000. Starting in 2024, the catch-up contribution for IRAs will be adjusted annually for inflation in increments of $100. Contributions are limited to the lesser of taxable compensation or these statutory limits:

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.

Lower income plan participants may also receive a Retirement Savings Contribution Credit (Saver's Credit) of up to $1,000 for a contribution of $2,000.

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.

There are different MAGI limits for deducting contributions for those taxpayers or their spouses covered by an employer retirement plan:

If income exceeds the phaseout limit, the taxpayer cannot contribute to an IRA. This is how the MAGI for a Roth IRA is calculated:

To calculate the reduced Roth IRA contribution limit:

1. Subtract the MAGI threshold from the MAGI: MAGI − MAGI Threshold
   1. Phaseout range
      1. = $10,000 for joint filing, qualifying surviving spouse (QSS), or married filing separately, if the taxpayer lived with the spouse at any time during the year
      2. = $15,000 for all other filing statuses
   2. If MAGI − MAGI Threshold ≥ Phaseout Range
      1. Contribution Limit = 0
2. Divide by the phaseout range
   1. (MAGI − MAGI Threshold) / ($10,000 or $15,000)
3. Round to 3 decimal places.
   1. ROUND(((MAGI − MAGI Threshold) / ($10,000 or $15,000)),3)
4. Multiply the contribution limit by the above fraction.
5. Subtract that amount from the applicable contribution limit.
6. Round the result to the nearest $10
   1. If result > $200, then result = contribution maximum
   2. If 0 < result < $200, then contribution maximum = $200
      1. If result = 0, then no contribution is allowed.
7. Subtract contributions made to other IRAs from the contribution limit for the year, then enter the lesser of the amounts just calculated.

The above steps are summarized in this equation using Excel spreadsheet formulas:

Spousal IRA

A taxpayer cannot contribute to a Roth IRA unless they have earned income, but there is an exception for married couples filing jointly. A working spouse can contribute to either a traditional or Roth IRA for a spouse who is not working or earns income below the statutory contribution limit, but the IRA must be in the name of that spouse. However, income limits for IRA contributions still apply. The statutory limit to contributions to the IRAs of both spouses is the lesser of joint taxable income or the sum of the contribution limits that apply to each spouse:

Total 2024-2025 statutory contribution limits:

• both spouses younger than 50: $14,000
• 1 spouse aged 50+: $15,000
• both spouses aged 50+: $16,000

Excess Contributions

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:

The excise tax can be avoided if the excess contribution + associated earnings are withdrawn by the due date of the tax return. Earnings are attributed to the tax year of the excess contribution. The withdrawn earnings, but not the withdrawn excess contribution, is added to taxable income.

If the taxpayer fails to withdraw the excess contributions and earnings, 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 funds are transferred from an retirement account to a different retirement account, which can be a similar account managed by a different trustee (i.e., traditional IRA to traditional IRA), or it could be a different type of retirement account (i.e., traditional IRA to Roth IRA) managed either by the same trustee or by a different trustee. A conversion is a special type of rollover that occurs when money is transferred from a tax-deferred account, such as a traditional IRA, to a tax-free account, such as a Roth IRA, managed by the same trustee. Rollovers from tax-free accounts to tax-deferred accounts are not permitted. This IRS chart summarizes the permissible rollovers: Rollover Chart (https://www.irs.gov/pub/irs-tege/rollover_chart.pdf)

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.

Several methods 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, 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, the taxable amount of a transfer is determined thus:

If the taxpayer elects to receive the funds to transfer to another retirement account, which must be completed within 60 days, then no more than 1 rollover per year is permitted. However, this 1-per-year limit does not apply to trustee-to-trustee transfers.

If the taxpayer is younger than 59½, any tax due on the transfer should be paid by the taxpayer rather than having it deducted from the transfer since a 10% tax penalty will be applied to the tax amount 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.

Roth Conversion May Increase Other Taxes or Reduce Benefits

Roth conversions increase taxable income, so this may trigger or increase other taxes, or reduce benefits, such as these:

• credits, exemptions, and deductions may be reduced or phased out
• taxes on Social Security benefits may increase
• alternative minimum tax may be triggered
• may affect financial aid eligibility

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 1 of these 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 tax-deductible contributions 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.

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. A Roth conversion cannot be recharacterized to 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.

Distributions

Qualified distributions from a Roth IRA are not taxable. A qualified distribution is any distribution from a Roth IRA that meets these requirements:

• the distribution occurs after a 5-year period that begins with the 1^st tax year for which a contribution was reported
  • or if any part of the distribution is allocable to a rollover or conversion, 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 the taxpayer 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 1^st home or for some other allowed exception
    • the 1^st home test means that the taxpayer did not have an ownership interest in a home within 2 years of acquiring a new home; both spouses of married couples must each satisfy this test

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 1^st 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, 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 not be subject to the 10% tax penalty, but will be taxable as ordinary income. (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 $90 on the amount, then to avoid the 6% tax penalty, withdraw $1090, include $1000 of the distribution as a nontaxable distribution on Form 1040, and report the $90 as income.

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 medical insurance premiums while the taxpayer was unemployed or unreimbursed medical expenses that exceed 7.5% of adjusted gross income;
• 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 repayment amount. However any repayments of qualified disaster recovery assistance distributions are 1^st considered a repayment of earnings, with any remaining portion increasing basis.

5-Year Rule for Roth IRA Distributions

If money is withdrawn within 5 years of January 1 of the year designated for your 1^st contribution to a Roth IRA, then the earnings, but not contributions, will be taxable. Because an IRA contribution can be made until Tax Day for the previous year, a contribution to a Roth IRA can be made on April 1 but designated for the previous year, which shortens the 5 years to less than 4 years. The 10% penalty does not apply if the distribution would otherwise be qualified. However, the initial 5-year holding period applies after opening the 1^st Roth IRA, including the year when the Roth IRA was set up, before earnings can be withdrawn tax-free. However, once the 5-year holding period is satisfied for 1 Roth IRA account, then this requirement does not apply to any other Roth IRAs that receive regular contributions. In other words, a new Roth IRA account can be set up and earnings can be withdrawn tax-free at any time if the 5-year holding period has been met by any of your Roth IRA accounts.

However, a new 5-year rule applies for any traditional IRA conversions to a Roth IRA, and the 5-year period starts for each conversion. However, designating a previous year applies only for contributions, not to conversions or rollovers, so the 5-year period for conversions or rollovers starts on January 1 of the year of the conversion or rollover.

Withdrawals are considered from contributions first, then from earnings. So, withdrawals of less than the total contributions to the account will be tax-free. Amounts exceeding total contributions will be treated as earnings, taxable if the 5-year rule is not satisfied.

Distribution Ordering Rules

To determine the taxable portion of any early distribution, the source of the distribution is attributed in this order:

• regular contributions
• conversion and rollover contributions
• 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:

1. 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.
2. 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.

Postmortem Distributions

If a Roth IRA owner dies, the amounts in the Roth IRA accounts must be distributed to beneficiaries. Although Roth IRA account owners do not have to take required minimum distributions (RMDs), beneficiaries who inherit the account, other than the surviving spouse, must take RMDs. If the beneficiary is a surviving spouse, the spouse can treat the IRA account as her own and will not need to take RMDs. For more details, see Required Minimum Distributions (RMDs).

Notes

• 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.
• Before 2018, losses on a Roth IRA were recognized when the total from all Roth IRAs for a given taxpayer is distributed and the distribution is less than the basis in the Roth IRAs, which is the total of contributions to all Roth IRA accounts. Before the 2017 Tax Cuts and Jobs Act (TCJA), losses were deductible as a miscellaneous itemized deduction subject to the 2% of AGI limit, calculated on Schedule A, Itemized Deductions of Form 1040, but the TCJA eliminated this deduction.