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What is a Roth IRA and what are the rules? The basics

At a glance:

  • How you can fund a Roth IRA

  • Roth IRA contribution rules

  • When are withdrawals allowed from Roth IRAs?

  • Roth IRA rollover rules

  • Summary of Roth IRAs

The Roth IRA is a type of individual retirement account.

The principal difference between the Roth and a traditional IRA is that while contributions to a traditional IRA are mostly tax-deductible and withdrawals are taxed, contributions to a Roth IRA are taxed, but qualified withdrawals are not taxed.

For some investors, the inability to deduct their contributions is a tiny price to pay for tax-free withdrawals that could be quite substantial after years of having grown in an account.

Of course, as in the traditional IRA, the earnings of a Roth are tax-free while they accumulate.

How you can fund a Roth IRA

An important part of establishing an IRA is having a custodian for the account. A custodian can be a bank, credit union, or other financial institution.

The custodian holds the funds that you contribute to your IRA. This is true for any funding vehicle.

You may use the following investments to fund Roth IRAs

The following investments may not be used to fund a Roth IRA:

  • Cash value life insurance

  • Collectibles

Roth IRA contribution rules

As in the traditional IRA, the most one individual can contribute to a Roth IRA for 2020 is $6,000 each year. These limits are $1,000 higher for individuals age 50 or older.

The most a married couple filing taxes jointly can contribute for 2020 is $12,000. These limits rise to $14,000 if both individuals are age 50 or older.

Contribution limits

How much you may contribute is limited for those above certain income levels:

  • If you are single, head of household, or married filing separately and did not live with your spouse, you are allowed to contribute the full amount as long as your adjusted gross income (AGI) does not exceed $124,000 in 2020. Participation in employer retirement plans does not limit your participation as it does in a traditional IRA. The Roth contribution is phased out as your adjusted gross income exceeds the yearly limit. At $139,000 in 2020, your allowed contribution drops to $0.

  • If you are married and you and your spouse are filing taxes jointly, your limit on adjusted gross income is $196,000 in 2020. At $206,000, your allowed contribution drops to $0. Between these limits, you must reduce your contributions accordingly (the IRS has publications to help you calculate this). Participation in other qualified retirement plans is not a barrier.

  • If you are married, lived with your spouse, and are filing separately, you are allowed to contribute up to the maximum as long as your adjusted gross income (AGI) does not exceed $10,000 per year. Between $0 and $10,000, your ability to contribute is slowly phased out. Participation in other qualified retirement plans is not a barrier.

You may simultaneously contribute to a traditional IRA, as long as the total placed into both accounts does not exceed the yearly limits. If you are married, the same amounts may be contributed for each of you to a spousal IRA.

Shot of a mature couple using a digital tablet while going through paperwork at home
If you are married, the same amounts may be contributed for each of you to a spousal IRA. (Getty)

If you contribute too much

A 6 percent tax is charged on excess contributions (contributions over the legal maximum) to the account. This tax will apply to each year that the excess remains.

For more information

To determine how much you may contribute to your Roth IRA, use Worksheet 2-2 in IRS Publication 590a.

When are withdrawals allowed from Roth IRAs?

Only qualified withdrawals of earnings are allowed from a Roth IRA. Qualified withdrawals do not incur taxes. They are what make the Roth IRA attractive to many investors seeking to fund their retirements.

Two criteria must be met for earnings to be qualified: the individual must be at least 59½, and the funds must have been in the account for at least five years. Withdrawals of contributions may be made anytime without tax or penalty.

Penalty tax and exceptions

The IRS considers any non-qualified withdrawal to be taxable income. All such withdrawals are subject to income tax on their earnings as well as the 10 percent penalty on early distributions. The 10% penalty tax does not, however, apply to the following situations:

  • You are disabled.

  • You are the beneficiary of a deceased IRA owner.

  • You use the distribution to pay certain qualified first-time homebuyer amounts.

  • The distributions are part of a series of substantially equal payments.

  • You have significant unreimbursed medical expenses.

  • You are paying medical insurance premiums after losing your job.

  • The distributions are not more than your qualified higher education expenses.

  • The distribution is due to an IRS levy of the qualified plan.

  • The distribution is a qualified reservist distribution.

One is not required to take distributions from a Roth IRA during one's lifetime.

For more information

IRS Publication 590b has more details on withdrawals.

Roth IRA rollover rules

A rollover is the moving of any investment from its current custodian to another. A Roth IRA must meet the following requirements to keep its tax-deferred status:

New IRS rule

You can make only one rollover from an IRA to another (or the same) IRA in any 12-month period, regardless of the number of IRAs you own, whether traditional, Roth, SEP, or SIMPLE.

You can, however, continue to make as many trustee-to-trustee transfers between IRAs as you want. A trustee-to-trustee transfer is one in which the trustee of your IRA (that is, the custodian holding it) transfers your IRA funds directly to another custodian instead of to you first.

You can also make as many rollovers from traditional IRAs to Roth IRAs ("conversions") as you want.

Rolling over funds from certain other retirement accounts

A recent IRS rule allows you to take after-tax portions of a 401(k), 403(b), or 457 plan and roll them into a Roth IRA. The advantage of such a move is that any growth in the Roth IRA will be tax-free (provided that you obey the rules for qualified withdrawals, of course), which is not possible in the other accounts.

Summary of Roth IRAs

The traditional IRA has been very popular among investors saving for retirement. However, for some retirees who retire with more taxable income than when they were working, the traditional IRA has some distinct disadvantages. Distributions would be taxed at a higher rate than the contributions would have been.

The Roth IRA was developed to address this issue. It allows persons who wish to save for retirement to invest after-tax dollars, which will grow tax-free, and then to receive tax-free distributions. Of course, like any IRA, there are contribution limits as well as rules against early withdrawal.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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