The Roth Individual Retirement Account

The Roth IRA presents a potentially attractive alternative to the traditional IRA. That's because a Roth IRA may allow you to avoid future taxation of your retirement funds by making nondeductible contributions now.

Rules of the Roth IRA

Following is a summary of the rules for Roth IRAs:

Unlike the traditional IRA, contributions to a Roth IRA are nondeductible regardless of your income level or participation in a company-sponsored retirement plan.

Your total annual contributions to all IRAs are limited to $6,000 in 2021. Individuals who are at least 50 years old by the end of the year are also able to make so-called catch-up contributions to a Roth IRA. The allowable catch-up contribution is $1,000 per year but is not adjusted for inflation. The contribution limit begins to decline or "phase out" for single taxpayers with adjusted gross incomes (AGIs) of more than $125,000 and for married couples filing jointly with AGIs of more than $198,000. Individuals with AGIs in excess of $140,000 ($208,000 for married couples filing jointly) are not eligible to contribute to a Roth IRA. Married taxpayers filing separately are not allowed to contribute to a Roth IRA if their AGI is $10,000 or more.

Contribution limits may increase in the years ahead. In the future, the annual contribution limit may be adjusted for inflation.

Qualified distributions from a Roth IRA are tax free. While your contributions to a Roth IRA are never tax deductible, your distributions may be tax free if you have owned the Roth IRA for at least five tax years, and:

• You are at least 59½ years old; or
• Your withdrawal of up to $10,000 (lifetime limit) is applied to a first-time home purchase; or
• You die or become permanently disabled.

You may qualify for the "first-time home purchase" if you have not owned a home for at least two years before the date on the purchase contract or the date when construction started. You, your spouse, or a child, grandchild, or ancestor of either may qualify as the buyer.

The taxable portion of a nonqualified distribution may be subject to a 10% tax penalty. If you make withdrawals that do not meet the rules for a qualified distribution, you'll owe taxes on all or a portion of the withdrawal. You must also pay a 10% penalty tax on the taxable portion of the withdrawal, unless an exception applies.

Penalty-free withdrawals are permitted for qualified education expenses. If you are under age 59½ but have held the Roth IRA for five tax years, you may withdraw funds penalty free to pay for qualified education expenses for yourself or family members. You will have to pay income tax on the taxable portion of the distribution, however.

Retirement plan "rollovers" are permitted. If you are changing jobs or retiring, you can roll over funds from an employer retirement plan, such as a 401(k) account, directly to a Roth IRA. The rollover is treated as a conversion, with income taxes due on any previously untaxed amounts.

Roth IRAs are not subect to minimum distribution rules. Unlike traditional IRAs, which generally require account holders to begin taking minimum distributions no later than age 72, Roth IRAs do not.

The Traditional IRA vs. the Roth IRA

When deciding whether a traditional IRA or a Roth IRA is suitable for you, you'll want to compare the after-tax dollars that would be available to you under each option. This will depend on many factors, including your tax bracket, how many years you have until retirement, and when you wish to begin making withdrawals. For many people, a Roth IRA will result in more after-tax income during retirement because qualified withdrawals from a Roth IRA are tax free, while withdrawals from a traditional IRA will be taxed (to the extent includible in income).

For those whose contributions to a traditional IRA are tax deductible and who are in a higher tax bracket today than they will be in during retirement, a traditional IRA may be the smart choice.

If neither you nor your spouse participate in a company-sponsored retirement plan, you can make deductible contributions to a traditional IRA regardless of your income level, up to the lesser of 100% of your earned income or $6,000 in 2021 (or $7,000 if you are at least 50 years old). Deductible contributions may be reduced or eliminated for individuals who participate in a company-sponsored retirement plan or whose spouses do, based on their incomes.

Conversion of a Traditional IRA to a Roth IRA

There are no income limits associated with the conversion of a traditional IRA to a Roth IRA -- anyone can convert, provided they pay the tax bill. Since the investment earnings and gains in your regular IRA have not been taxed yet, these are taxable at the time of the conversion. If you have made nondeductible contributions to a traditional IRA, earnings will be taxed but your nondeductible contributions will not.

Which Is Right for You?

If you have a traditional IRA and are considering converting to a Roth IRA, here are a few factors to consider:

• A Roth IRA may be more attractive the further you are from retirement. Why? Because the longer your earnings can remain invested, the more income you may have that is never taxed. On the other hand, if you convert to a Roth IRA close to retirement, your investments may not have much time to help compensate for the associated tax bill.
• If your traditional IRA contributions are nondeductible, you may be better off with a Roth IRA. That's because the distributions of earnings from your traditional IRA will eventually be taxed. The qualified distributions from a Roth IRA will not.
• Your current and future tax brackets will affect which IRA is best for you. For example, if you are currently in a high tax bracket and expect to be in a much lower tax bracket during retirement, a traditional IRA could be the better option. Why? Because you may be able to claim a deduction on your contributions now and then pay taxes on future distributions at the lower rate later.

As you can see, there is no easy answer to the question, "Which IRA is best for me?" As with any major financial decision, careful consultation with a financial professional is a good idea before you make your choice. In addition to helping you with calculations and projections, a financial professional is also likely to know what, if any, changes or clarifications have been made to the complex new tax laws. Remember, your retirement could last 20 years or more. How you live tomorrow could depend on the choices you make today.

The information contained herein is general in nature and is not meant as tax advice. Consult a tax professional as to how this information applies to your situation.