5 Roth IRA Rules You Should Know Before Opening an Account
I am a big supporter of the Roth IRA. I love to talk about it and recommend it to anyone who can keep the conversation going.
But what I discovered is that a lot of people don’t understand how the Roth IRA is such a great investment vehicle.
Moreover, many of those who have it have absolutely no idea how to best use it.
This is important because the Roth IRA is one of the best long-term investment accounts you can have.
That is to say, if you manage it correctly. A lot of people don’t, and that’s when it starts to look less appealing.
Whether you are considering opening a Roth IRA or already have one in place, there are five things you need to know to make the account work for you as it should.
1. How Much Can You Put in a Roth IRA?
For 2020, the maximum contribution to a Roth IRA is $ 6,000 per year. But if you’re 50 or older, that drops to $ 7,000 a year.
There is a small catch with this contribution. It is only available to those who have earned an income. This includes income from wages, salaries, commissions, bonuses, self-employment, self-employment and contract work. For example, if you have $ 20,000 in earned income, you can make the full contribution allowed. But if you only earn $ 4000, that will be your maximum contribution.
The $ 6,000 / $ 7,000 contribution has another limit – this is the maximum you can contribute to one or a combination of IRA accounts. This includes both Roth IRAs and Traditional IRAs.
This means that if you contribute $ 6,000 to a Roth IRA with one broker, you cannot contribute to a second. On the other hand, you can split your contribution between two brokers, with $ 3,000 in each account.
2. Set up Roth IRA accounts for your spouse and children
Most people don’t know that you can have a Roth IRA account for anyone and anyone in your family who has earned income.
In fact, there is even an exception for your spouse. Under a spousal IRA, you can make a contribution of up to $ 6,000 (or $ 7,000 if 50 or older) even if your spouse has no earned income. As part of this special type of IRA, you can make a contribution to traditional Roth or IRA accounts for you and your spouse, provided that you have sufficient professional income to support the two contributions.
For example, if you earn $ 100,000 per year and your spouse has no earned income, you can contribute $ 6,000 to a Roth IRA account for you and your spouse, for a total of $ 12,000. .
On the other hand, if you only earn $ 10,000, that will be the maximum contribution you can make to the two accounts combined.
To be eligible for the Joint IRA, your partner must be your spouse. It can’t be a girlfriend, boyfriend, or fiance.
But it doesn’t stop with your spouse. If one of your children has earned income, you can open a Roth custodial IRA for that child. Contributions will be eligible if your child has a part-time job or earns money babysitting, mowing the lawn, or doing similar activities.
One limitation however is that if the income received is not reported to the IRS, it will not be eligible for contributions. Contributions are based on the income reported on your tax return.
I do this with my own children. Since I have a business, my children work for me, for which I pay them. I then make a contribution to each child’s custody Roth IRA up to the amount of income they earn. It’s one way to create a tax-free money portfolio for their future.
3. Gradually withdraw
The IRS places an income cap on your ability to contribute to a Roth IRA. If you earn more than this limit, you will not be able to contribute to a Roth IRA.
This is very different from traditional IRAs, where the contribution is no longer tax deductible if you are covered by an employer-sponsored retirement plan and your income exceeds a certain level. In this case, you can still contribute to a traditional IRA – it just won’t be tax deductible.
This is not the case with the Roth IRA. If you exceed the income thresholds set by the IRS, you won’t be able to make a Roth IRA contribution, period.
The current income limits beyond which you can no longer make a Roth IRA contribution are as follows:
- One-time contribution, full up to $ 124,000, partial contribution up to $ 139,000, after which no contribution is allowed
- Married declaring jointly, full contribution of two $ 196,000, partial contribution up to $ 206,000, after which no contribution is allowed
But there are a few workarounds. For qualifying purposes, your income for the Roth IRA is based on what is known as Modified Adjusted Gross Income, or MAGI.
One of the changes to MAGI are the tax deductible 401 (k) contributions. If you make contributions to an employer-sponsored plan, which are tax deductible, they will also reduce your MAGI. It is possible that these contributions will reduce your income enough to qualify you to make Roth IRA contributions.
To give an example, if you are a single person earning $ 139,000 per year – which would prevent you from making a Roth IRA contribution – but you contribute $ 19,500 to your company sponsored 401 (k) plan, your MAGI will drop to $ 119,500. You will be allowed to make at least a partial Roth IRA contribution.
There is also a second workaround, but it’s a bit more complicated.
The Roth IRA “backdoor”
This type of Roth IRA contribution is called back door because it starts out as a contribution to a traditional IRA.
As I wrote earlier, there is no income limit for making a contribution to a Traditional IRA. The only limit applies to the tax deductibility of the contribution if you are covered by an employer plan and your income exceeds a certain limit.
But the basic idea of a Roth backdoor IRA is that you fully contribute to a traditional IRA. The contribution is paid on a non-tax deductible basis. This is really the key to the whole strategy.
Since you can convert a Traditional IRA to a Roth IRA at any time, you can contribute to the traditional account and then convert to a Roth IRA immediately.
Now, every time you do what’s known as a Roth IRA conversion – which is the term used to convert a traditional IRA or other tax-deductible retirement plan into a Roth IRA – you have to pay taxes on the balance amount converted.
However, in the case of a backdoor Roth IRA, you will not pay tax on converting your traditional IRA contribution to your Roth IRA plan. This is because the traditional IRA contribution was never tax deductible in the first place. Since there is no tax benefit when the contribution has been made, there is no tax payable when it is converted to a Roth IRA.
4. Roth IRA contributions
Remember how I said that contributions to a Roth IRA are not tax deductible? This comes with its own benefit.
Since contributions are not tax deductible, they can be withdrawn at any time exempt from ordinary income tax and the 10% early withdrawal penalty which generally applies when you withdraw funds from the account. retirement before turning 59 and a half.
Now, the income you earn from investing in your Roth account is treated like withdrawals from any other pension plan. If some of that money is withdrawn before you turn 59 and a half, you will be subject to both ordinary income tax and the penalty.
But under IRS ordering rules, you can withdraw your contributions from a Roth IRA before your accumulated investment income.
Unlike other retirement plans, where you have to tie up your money for decades, or face taxes and penalties, the Roth IRA allows you to access your contributions at any time.
There is one limitation you should be aware of when it comes to early withdrawals. If the value of your Roth IRA falls below your total contributions, you will be limited to withdrawing the equity from the account, not the amount of your original contributions.
5. How do I invest in a Roth IRA?
One of the biggest mistakes people make with the Roth IRA is holding it with banks or credit unions. If you do, your money will be held in low-yielding investments, such as certificates of deposit and money market accounts. These do not pay more than 1% or 2% per year. These are not the types of investments that will make your Roth IRA grow the way it should.
A Roth IRA is a retirement account, which means you have to invest for the long term. And since you probably have decades to invest, you will need to add high risk / high reward investments to the mix. This includes stocks, mutual funds, exchange traded funds, real estate investment trusts, and similar investment vehicles. To do this, you will need to move your plan to the correct investment account.
You will need investments designed to generate long-term growth. For example, the average annual return on stocks has been 10% since the 1970s. If the majority of your Roth IRA is invested in stocks, your account will grow rapidly and produce a healthy retirement nest egg by the time you are ready to invest. start making withdrawals.
The Roth IRA is one of the greatest investment vehicles ever. If you don’t have it in your financial toolbox, you need to add it. Just make sure you fund it regularly and invest it aggressively for the best results.