In the first part of our three part series on retirement savings options outside of employer sponsored plans, we will be discussing the Roth IRA. Many people have heard of the Roth IRA, or perhaps even been advised to open a Roth IRA by a parent, family member, or friend. As with many things in life, taking the first step in deciding to establish this type of account can be intimidating. However, there is no need to feel that way! We will be discussing who can participate in a Roth IRA, what are the contribution limits, and most importantly what makes the Roth IRA such a powerful long-term savings tool. Let’s dive in!
Who can participate?
There is no age restriction on who can open and contribute to a Roth IRA. The only requirement is that the account holder making contributions have earned income. Earned income is money made through working a job or through business ownership. Passive income types such as rental income, alimony, investment income, social security, and unemployment compensation are a few examples of unearned income that cannot be used to qualify for participation.
Participation is also limited by your MAGI (modified adjusted gross income) for the tax year in which you are making contributions. We will cover more on that in the next section.
As we will discuss in further detail below, keep in mind that your annual contribution limit cannot exceed your amount of earned income. For example, you must have at least $6,000 in earned income to be able to make the full allowable annual 2020 contribution of $6,000.
What are the contribution limits?
Roth IRA contribution limits can fluctuate slightly each year, but the maximum contribution limit for the 2020 year is $6,000 per person ($7,000 if you are 50+). Roth IRA contribution limits can be affected by the MAGI (modified adjusted gross income) of the account holder based on their tax filing status.
The participation phase-out window for a single filing tax payer is from $124,000 to $138,999. With participation being entirely disallowed with MAGI exceeding $138,999. Married filing jointly taxpayers face a phase-out window of $196,000 to $205,999. Participation for married filing jointly taxpayers completely phases out at MAGI equal to or in excess of $206,000.
What makes the Roth IRA special?
So, I know that by now you are probably asking, “What makes this Roth IRA savings option so attractive?” The answer to that questions is the unique quality of a Roth IRA that allows your after-tax contributions to grow tax-free for the life of your account and your withdrawals are also tax-free (if over age 59.5). This is the reason why a Roth IRA is a preferred savings method for someone in their 20’s and 30’s. The time that your invested money can grow tax-free until age 59.5 adds an immense amount of value to your investment.
If I have an emergency, can I access my funds prior to age 59.5?
The short answer is yes. The real answer is that if you are under age 59.5 and have not owned the account at least five years, your earnings are subject to taxes as ordinary income and are also subject to a 10% penalty. If you are under age 59.5 and have owned the account at least five years, your earnings are still subject to tax as ordinary income and you face a 10% penalty. If you are over age 59.5 and and have owned the account at least five years, there are no taxes or penalties assessed on any withdrawals. If you are over age 59.5 and have not owned the account at least five years, your earnings are subject to tax as ordinary income but there is no 10% penalty assessed.
Note: If you are under age 59.5, you may qualify for one of the exceptions to allow a withdrawal not subject to the 10% penalty (but not the tax). The exceptions are first-time home purchase, qualified education expenses, unreimbursed medical expenses, and disability.
I’m ready to open an account, what’s next?
If you are ready to enter the world of retirement savings through use of a Roth IRA, it is always a good idea to find a professional financial advisor (preferably a Certified Financial Planner) who serves as a fiduciary and protects your best interest when making investment choices. If you are interested in connecting with a CFP partner of ours, please reach out through the contact form on the blog page or email us at wisdomofwealthblog@gmail.com.
Be on the lookout for part two of the series next week!
-Wes
Check out our CPA firm website here.
Check out our small business cloud accounting service here.
Note: The information contained within this blog post is current with applicable laws and regulations as of the publishing date. Financial regulations are subject to change.