Episode 83: The Beautiful Roth IRA

the roth ira

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One of the best planning tools that we have in our toolbox, when we’re saving for retirement, is a gift from Uncle Sam: the Roth IRA. This tool is something that can be used by the majority of Americans that work.

Benefits of a Roth IRAs

  1. It lets you put the money in after tax, so you don’t get to deduct the money from your income in the tax year. But, you get to take the money out tax free.
  2. If you put money into a Roth, you can pull out your contributions at any time without taxes or penalties.
  3. You can withdraw from the Roth at any time to purchase a home.
  4. There’s no required minimum distribution from a Roth IRA.
  5. You can continue to make contributions to your Roth IRA after age 70, as long as you’re still working.

There are some limits on how much you can contribute to a Roth IRA. First, you can only contribute up to the amount of earned income, with a non-working spouse able to contribute from the working spouse’s income. There are also income limits for Roth IRAs. Lastly, there are limits on how much you can contribute each year. (That’s $5,500 for 2018, plus $1,000 additional catch-up if you’re over age 50.)

Distributions from Roth IRAs

Where Roth IRAs can get tricky is when you get to distributions. There are a bunch of different rules, and each type of distribution may come under a different rule. We’re going to talk about contributory IRAs here, those are IRAs where you are actively contributing, not conversion IRAs.

On a contributory IRA, which is one that you’re adding money each year, your contributions are always sitting there free and ready to go without penalty or taxes. However, there are slightly more complicated rules for taking out your earnings, depending on when you pull them out and how long you’ve had the account. There are a variety of ways that you can withdraw money without penalties and/or without taxes.

Some ways you can access the earnings on your income before age 59 1/2 without penalty, but possibly with taxes:

  • First time home buying, up to $10,000
  • Qualified education expenses
  • If you become disabled
  • If you’re making a distribution in “substantially equal periodic” payments
  • If the withdrawal is a tax levy (but not if you take a distribution to pay taxes)
  • If you are a military reservist called to active duty for more than 180 days

Then, there are qualified distributions and non-qualified distributions. A qualified distribution is when your Roth IRA has been open more than 5 years. A non-qualified distribution is when your Roth IRA has been open less than 5 years. This is often called the 5 year rule.

Then, are the earnings subject to taxes and/or penalties? If you’re less than 59 1/2, and your distribution is non-qualified, then those earnings will be subject to taxes and penalties. If you’re less than 59 1/2, and your distribution is qualified, the earnings are only subject to taxes, not penalties.

After age 59 1/2, there are no more penalties. As long as the Roth IRA has been open at least five years, then there are no taxes or penalties.  If the Roth IRA has been open less than five years, and you’re over 59 1/2, you’re still going to pay taxes on the earnings, but no penalties.

Roth IRAs and Social Security

It’s important to understand how Roth IRAs can impact whether your Social Security income is taxed.

Taxation on your Social Security benefits is based on your “provisional income.” As you get a higher level of provisional income, more of your Social Security is taxed. Your provisional income is basically all your income, plus 1/2 of your Social Security income, but it doesn’t include distributions from Roth IRAs. That means if you’re taking distributions from a Roth IRA, then you may have a lot more income while paying less tax on your Social Security benefits.

Come back next week to learn about doing conversions from traditional IRAs to Roth IRAs, including conversions for people who make too much money to contribute under the regular rules.

Highlights:

The amazing amount of growth you can make with even small contributions

How you can get into a Roth IRA even if you make too much money

The difference between qualified and non-qualified distributions

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Every few weeks, Devin and John answer reader questions during the show.  Send your questions to questions@bigpictureretirement.net.