Roth IRA: Tax-Free Income in Retirement

Shawn Plummer

CEO, The Annuity Expert

A Roth IRA is a retirement account that allows you to save money and grow your personal wealth tax-free. With the money you contribute, the government will not take income taxes from it when you withdraw funds in retirement. This post will cover everything an account holder needs to know about Roth IRA rules!

What is a Roth IRA?

Roth individual retirement accounts (IRA) are financial products for U.S. residents, paid with after-tax dollars. A Roth IRA owner can make money without paying taxes on it. It was named after William Roth, a former Delaware Senator.

You can put money into these investment vehicles with your own money. It is not tax-deductible, but it will be free from taxes when you take the money out of the account.

If you work, you can put earned income into your retirement account.

How Does A Roth IRA Work?

A Roth IRA is a retirement account that allows you to contribute after-tax dollars and withdraw the money income tax-free in retirement. Unlike a traditional IRA, there are no income taxes on withdrawals from Roth IRAs.

Contributions to Roth IRAs are not tax-deductible, but the earnings grow tax-free. Withdrawals can be tax-free if they meet certain conditions, such as being taken after age 59½ or used for a qualified first-time home purchase.

Roth IRA Contribution Limits

Like a traditional IRA, a Roth IRA has a contribution limit. In 2022, the annual contributions limit is $6,000 this tax year. In addition, people aged 50 or older can deposit up to $7,000 in Roth IRA contributions.

Who Can Not Contribute To A Roth IRA?

There are income limits to participating in this retirement plan for investors in a higher tax bracket. If the annual income exceeds $144,000 a year in gross income as an individual, or if a married couple’s income exceeds $214,000 a year together, then the joint filer cannot contribute to a Roth IRA.

You can not contribute to a Roth IRA if you do not receive earned income.

Roth IRA Basis Of Contributions

The contributions to a Roth are known as its IRA basis and can be withdrawn and used without tax. Contributions in Roth IRAs are free for you to use. You do not need to pay income tax on them to invest with them.

Required Minimum Distributions (RMD)

Unlike a traditional IRA, there are no required minimum distributions (RMD) if you invest in a Roth.

How To Open A Roth IRA

A Roth IRA account must be created with a company that the IRS approves. This includes banks, brokerage companies, federally insured credit unions, insurance companies, financial institutions, and savings and loans. Financial advisors typically set up the accounts.

You can open a Roth at any time. But it would be best to do it before the owner’s tax filing deadline, which is usually April 15th of the following calendar year. After that, you cannot get an extension on the tax filing status.

What Type Of Money Can Be Contributed

Only earned income can be contributed to a Roth savings account.

W-2 Employees

If you are a W-2 employee, the money you make from your job can pay for a Roth IRA. Things like wages, salaries, commissions, and bonuses can all count.

Self-Employed

If you are self-employed, compensation is the individual’s net earnings from their business, less deduction allowed for contributions made to retirement plans on the individual’s behalf, and further reduced by 50% of the individual’s self-employment taxes.

Divorce

Money related to divorce can also be contributed. This is called alimony. Child support or money from a settlement can also be put in the account.

What Type of Money Can Not Be Contributed

The IRS limits the type of Roth IRA contributions that can be made to retirement accounts. These income sources are prohibited:

Spousal Roth IRA

A married partner can fund their spouse’s Roth account. It doesn’t matter what their income is. Spousal Roth IRAs are the same as regular Roth IRAs, but they must be held separately from each other’s accounts.

Eligibility

  • You are married and file taxes jointly.
  • The individual making the Roth IRA contribution must use earned income.
  • Make less than $208,000 as a household.

What Age Can You Withdraw From A Roth IRA Without A Penalty?

Generally speaking, you can withdraw funds from your Roth IRAs without a penalty once you reach the age of 59½. However, there are a few exceptions to this rule. For example, use the money for qualified higher education expenses or to cover certain medical costs. In addition, you may be able to withdraw funds before reaching the age of 59½ without incurring a penalty.

What Happens If You Withdraw Funds From Your Roth IRA Before Reaching The Age Of 59½?

If you withdraw funds from Roth IRAs before reaching the age of 59½, you will typically have to pay a ten percent early withdrawal penalty. However, there are a few exceptions to this rule. For example, if you are disabled or if you use the money for qualified higher education expenses or to cover certain medical costs, you may be able to withdraw funds without incurring a penalty.

When Can You Withdraw From A Roth IRA?

Qualified Distributions

You can take your money from a Roth IRA without taxes or penalties. For example, if you only take out what you put in, the retirement savings is not taxable, and there are no penalties. This is known as a qualified distribution.

If you have a Roth account and want to get the money out of it penalty-free when you are older, it must happen at least five years after the first time you put money in. To receive withdrawals (free of income taxes), the money has to come out under one of these conditions:

  • Owners are at least 59½ when they take money out of their Roth IRAs.
  • The distributed assets must be used to buy, build, or rebuild a first home. This can only happen for $10,000 per lifetime.
  • The Roth IRA distributions can happen after they become disabled.
  • The beneficiary of inherited Roth IRAs will get the money after that person dies.

5-Year Rule

When you withdraw money from your account, it may be taxed. The percentage of taxable income depends on how old you are. If you have met the 5-year rule, there is no tax or penalty when withdrawing your account.

You’ve waited at least five years:
  • Younger than 59½: Earnings are taxed and penalized by 10% (Early Withdrawal Penalty). You can avoid taxes and penalties if you use the money to buy your first home. You can also avoid taxes if you have a disability or die.
  • Age 59½ and older: No taxes. No penalties.
You have not waited for at least five years:
  • Younger than 59½: Earnings are taxable compensation and are penalized by 10% (Early Withdrawal Penalty). You can avoid penalties if you use the money to buy your first home. You can also avoid penalties if you have a disability, die, or use the withdrawal for qualified education expenses.
  • Age 59½ and older: You are paying the taxes but avoiding the penalties.

Non-Qualified Distributions

If you take money from your Roth account too early, you may have to pay tax and a 10% penalty. The exceptions are:

  • Unreimbursed medical expenses. It is okay if you use the money to pay for medical bills that are more than 10% of what you make in a year.
  • If someone has lost their job, they might need to pay for their medical insurance.
  • The withdrawal is used for qualified higher-education expenses. This includes tuition, fees, books, supplies, and equipment required for enrollment or attendance.
  • You can get up to $5,000 for your pregnancy or adoption if you withdraw within one year of giving birth or adopting.

Roth Vs. Traditional IRA

When it comes to saving for retirement, there are a lot of options available. Two of the most popular options are Roth IRAs and traditional IRAs. Both have advantages and disadvantages, so it’s essential to understand the difference before choosing one.

  • With a traditional IRA, you pay income tax on the money when you withdraw it in retirement. However, you may be eligible for a tax deduction on your contribution.
  • With a Roth individual retirement account, you pay with post-taxed money when you contribute, but you don’t have to pay taxes when you withdraw it in retirement. As a result, Roth IRAs offer more tax benefits if you expect to be in a higher tax bracket when you retire.

If you’re unsure which option is right, talk to a financial advisor who can help you make the best decision for your unique situation.

How To Open Start A Roth IRA

Here’s how to open and start a Roth plan:

  1. First, you’ll need to choose a bank, financial institution, brokerage services, or insurance company that offers Roth IRAs.
  2. Once you’ve selected a provider, you’ll need to open an account and make an initial deposit. The IRS limits the amount you can contribute each tax year, so check the contribution limits before making your deposit.
  3. Once your account is open and funded, you can start investing in various assets, including stocks, bonds, and mutual funds.

Roth Conversion: The Back Door Roth IRA

A Roth IRA conversion, also known as the Backdoor Roth IRA, allows IRA owners to convert their traditional IRAs into Roth accounts. This provision allows investors to:

  • Pay the ordinary income tax on their tax-deferred savings, and earn interest, free of income taxes.
  • Receive tax-free income when they retire.
  • Withdraw their contributions at any time, without paying taxes.
  • Avoid required minimum distributions (RMD) in the future.

The “back door” strategy includes contributing to a traditional IRA and immediately converting to a Roth IRA. Once the conversion is complete, the owner must leave the funds untouched in the newly converted Roth IRA for five years; otherwise, they will pay a 10% penalty if they are under 59 1/2.

Roth Conversion Age Limit

Currently, there are no age limits for a Roth Conversion.

Can I roll Over A 401(k) To A Roth IRA?

If you have a 401(k) through your employer, you may also be able to roll those funds into a Roth IRA. When you do a rollover, you convert the money from your 401(k) into a Roth IRA. The amount you convert is taxed as regular income in the year you do the conversion. After that, all future growth is tax-free, and withdrawals are tax-free.

Guaranteeing An Income For Life Without Taxes

Once the requirements are met, an owner can transfer their account into a Roth annuity with a lifetime income rider. The annuity will then distribute tax-free payments for the rest of the retiree’s or married retirees’ lifetimes, even after the Roth IRA has run out of money. The Roth IRA annuity is a great way to layer retirement income in addition to Social Security income while protecting against market volatility.

Younger investors can contribute to a Roth annuity for tax-free growth or convert their traditional IRAs into a Roth annuity and guarantee their future income during retirement. Eligible individuals should contribute as much money as possible to the savings account before making traditional IRA contributions.

Roth IRA Calculator

Determine how much in tax-free withdrawals you’ll receive for the rest of your life with our calculator.

Next Steps

A Roth annuity can provide a lifetime of tax-free income, making it an attractive retirement option. Contact us below if you’re interested in learning more about how an annuity could benefit you in retirement. We can help you find the right plan for your unique needs and walk you through the application process so that you can rest easy knowing your retirement is taken care of.

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Frequently Asked Questions

What is the Roth Basis?

The Roth IRA basis is the total amount of money you have contributed to your Roth IRA account. This includes any contributions you have made on an after-tax basis and any conversion amounts. The Roth IRA basis also includes any earnings on your contributions. When you take distributions from your Roth IRAs, you will only pay taxes on the amounts that are above your basis.

Can Roth IRAs lose money?

Roth IRA investments can lose money if the account is set up traditionally with investment options (stocks, bonds, mutual funds). However, Roth IRA savings can not lose money if the account is set up as a fixed or fixed index annuity.

Is there a Roth IRA Tax on gains?

No. As long as the Roth IRA owner follows IRS guidelines, there are zero taxes owed on Roth IRA gains.

Do Roth IRAs earn interest?

Roth IRA accounts are a great way to save for retirement, but you may wonder if they earn interest. The answer is yes! A Roth IRA will accrue interest over time like any other savings account. The interest rate on your Roth IRA will depend on the financial institution where you open your account and the current market conditions. However, over time, the interest on your Roth IRA can add up, increasing your money available for retirement.

Should I use a Roth IRA as a savings account?

A Roth IRA can be a great savings account if you are nearing retirement or are already retired. The most significant benefit of a Roth IRA is that you do not have to pay taxes on the money you withdraw.

Is it better to contribute to a retirement plan with money you paid taxes on or contribute to pre-tax accounts and receive tax deductions today?

If you contribute to a retirement plan with money you paid income tax already (Roth), you will not be able to take a deduction for those contributions today. However, the money in the Roth account will grow and be withdrawn tax-free in retirement. On the other hand, if you contribute to a pre-tax account (traditional IRA), you can take a deduction for your contributions today. However, you will be required to pay taxes on the money when you withdraw it in retirement.

Where should I put my money after I maxed out the contribution limit?

Once you’ve maxed out your contribution limit, you may wonder where to put your money next. One option is non-qualified annuities. Only the interest will be taxable income in retirement.

Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you. 

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