Investment Glossary – Roth IRA
A Roth IRA is a type of investment account that gives you no additional benefits when you put money into it, but has the potential to accumulate significant benefits over time, since when you pull money out later on, it comes out completely tax-free. That’s right – there are no income taxes due upon the withdrawal, no capital gains taxes due upon the withdrawal, there are no taxes at all due upon the withdrawal – provided you have waited at least five years since your first contribution to begin withdrawing money. Anyone can set up a Roth IRA, but there are some limits as to how much income you can make if you want to directly contribute into it, and there are also annual limits on how much you can put into it. Let’s walk through the mechanics.
The money that you put into a Roth IRA must be funded with after-tax income.
Those last three words imply two things – first, that you and/or your spouse must have income to be able to contribute to a Roth IRA, and second, that you do not receive any tax benefit in the year you make your contribution. You cannot fund a Roth IRA with income earned on bank accounts or investment accounts. You must have W-2 or 1099 income in order to make contributions.
As mentioned in the initial paragraph, there are some limitations when it comes to how much you can contribute to a Roth IRA. There’s also eligibility criteria based on how much income you earn. The maximum contribution in 2020 remains $6,000, the same as it was in 2019. For investors age 50 and older, you’re able to contribute an additional $1,000 each year, or $7,000 total in 2020. If your earned income is less than those amounts, you can only contribute up to the amount of income you earned in that year, rather than the IRS-specified maximum. For example, if you earned $4,000 in 2020, you can only contribute up to $4,000 into a Roth IRA, rather than the $6,000 limit for 2020.
However, there’s another factor out there that will determine if you can contribute to a Roth IRA as well – whether you make too much money. In 2020, if you have Modified Adjusted Gross Income (MAGI) north of $124,000 as a single filer or $196,000 as a joint filer, your ability to contribute to a Roth IRA will phase out, with that ability eliminated at $139,000 for single filers and $206,000 for joint filers. If you have an ice cream headache from the numbers, call a tax preparer because they know this stuff cold and enjoy doing math (unlike most people).
So who actually benefits from contributing to a Roth IRA? Time for more math. But the basic principle is that a Roth IRA may be beneficial when your current tax bracket is low and expected to rise in the future, and the link in the previous paragraph will walk you through the mechanics of how to start figuring out if a Roth IRA contribution is right for you.