Saving for retirement can be a challenge, but luckily there are several tools that can help you reach your financial and retirement goals. Ranging from Traditional and Roth 401k plans, IRAs, 403(b) plans and others, it can be difficult to keep up with all the requirements and rules for the different types of accounts that are available. In this article, we’ll focus on a retirement plan that is becoming increasingly popular: the Roth IRA. Roth IRAs can be a great option for your retirement savings, but there are some rules to keep in mind if you are considering taking advantage of this type of account.
Roth IRAs can be a nice investment tool to use as you pool money for your future retirement or savings. Similar to a traditional IRA account, Roth IRAs allow your investments to grow in a tax-advantaged manner, but a key difference is a Roth IRA offers tax-free growth and withdrawals under the right circumstances, whereas with a Traditional IRA, your contributions may be tax-deductible in the year they are made.
Similar to other tax-advantaged retirement plans offered to Americans, there are specific rules regarding Roth IRAs. In this article, we’ll cover eligibility requirements, income limits, contribution limits, and other rules for you to keep in mind if you are considering a Roth IRA in 2021.
Roth IRA Eligibility Rules
Many of the rules around Roth IRAs have to do with who is eligible to contribute to one. One of the main eligibility requirements is that you must have earned income. Earned income can come in several forms, including commissions, tips, bonuses, taxable fringe benefits from an employer who pays you, or through the income from your own business. Additional types of income that can help fund your Roth IRA are combat pay, disability benefits, or taxed alimonies.
It’s important to note that there are certain types of resources that will not qualify as earned income, and therefore not able to be used to contribute to a Roth IRA. For example, non-taxable alimony, unemployment benefits, social security benefits, child support, and any type of investment income from securities, rental properties or other assets are considered “unearned income.”
Roth IRA contributions don’t have an age requirement so even young students and teenagers can open a Roth IRA and contribute their earnings from a summer job into their account, as long as their earned income is within the set limits for Roth IRAs.
2021 Roth IRA Income Limits
Your Modified Adjusted Gross Income (MAGI) and tax-filing status (single, married filing jointly, married filing separately) will also determine your if you are eligible to contribute to a Roth IRA for 2021. Your Modified Adjusted Gross Income is calculated by taking the Adjusted Gross Income (AGI) from your tax return and adding back in certain deductions such as student loan interest, self-employed taxes, home interest payments and higher education expenses. You can visit the IRS website and access Worksheet 2-1 to calculate your Modified Adjusted Gross Income.
For those married and filing jointly, if your 2021 MAGI is below $198,000, you can contribute up to the yearly maximum of $6,000 (or $7,000 if you are age 50 or older). The contribution limit to a Roth IRA begins to phase out and decreases for married households that have a MAGI between $199,000 and $207,000, and those who report more than $208,000 in MAGI are ineligible to contribute to a Roth IRA.
Married couples that file separately and report MAGI levels exceeding $10,000 will not be eligible to contribute to a Roth IRA, whereas those who report a MAGI below $10,000 will be able to contribute at a reduced level. Tax filers that report as Head of Household or Married Filing Separately, but have not lived with their spouse in the past year will be able to follow the below limits and rules for singles.
Single tax filers who have a 2021 Modified Adjusted Gross Income below $125,000 will be able to contribute up to the maximum amount of $6,000 (increases to $7,000 if you are age 50 or older). The contribution limit begins to phase out for single filers who report MAGI levels between $126,000 and $138,500, while those who report more than $140,000 for their MAGI will not be eligible for a Roth IRA contribution.
Learn More: Can I Contribute to a 401k and an IRA?
2021 Roth IRA Contribution Rules
In addition to restrictions around income, there are a few other rules around Roth IRA contributions that you should be aware of. For example, it’s definitely possible to own both a Traditional IRA and a Roth IRA, but the yearly contribution limit applies collectively to both types of IRAs. For example, if Mary is younger than 50 years old, files her taxes as a single and reports a MAGI level below $125,000, she can deposit up to $6,000 and split the amount in any manner between her Traditional and Roth IRA. She just can’t exceed $6,000 in total contributions. It should also be noted that Mary might not want to contribute to her Traditional IRA in this scenario due to her high income level and deductibility rules.
Contributions to Roth IRAs can be made until the federal tax filing day of the following year. Using our above example for Mary, she will be able to contribute to her Roth IRA for 2021 until the federal tax deadline of April 15, 2022.
What if you have an existing Traditional IRA or employer-sponsored retirement plan such as a 401k and would like to move those funds into a Roth IRA? This can absolutely be done, and is called a Roth Conversion. It’s important to note that conversions from other retirement accounts have no impact on your 2021 contribution limit, but may increase your total Modified Adjusted Gross Income (MAGI) and therefore trigger a phaseout of your Roth IRA contribution amount. Those who are not eligible for Roth Contributions due to income limitations are generally still eligible to convert dollars from Traditional retirement plans. Talk with an accountant to see if this makes sense for your financial plan.
Tax Benefits of Roth IRA Contributions
One of the main perks of contributing to Roth IRAs is that you will not be taxed when you ultimately take out your contributions in the future since Roth IRAs are funded with after-tax dollars. So if you’re looking for a current tax deduction, a Roth IRA is probably not the ideal investment tool.
However, if you are 18 years old or older, not claimed as a dependent on another person’s tax return, and not a full-time student, then you may be eligible for a tax credit of 10%, 20%, or 50% on the first $2,000 ($4,000 if married filing jointly) contributed to a Roth IRA through the Retirement Savings Contributions Credit, also known as Saver’s Credit.
For 2021, taxpayers who are married and filing jointly must have Adjusted Gross Income (AGI) levels below $66,000 in order to qualify for the Saver’s Credit. Those who file as head of households must report an AGI below $49,500, and single taxpayers must have incomes below $33,000.
Roth IRA Withdrawal Rules
As I mentioned earlier, one of the biggest perks of a Roth IRA is that withdrawals are tax-free when you ultimately take money from the account. With Roth IRAs, you can leave your money untouched if you want to keep the funds in the account as there are no required minimum distributions (RMDs) until it potentially becomes inherited.
Keep in mind there are several rules to follow to help you avoid having to pay taxes or penalties for withdrawing your earnings from a Roth IRA.
If you are 59½ years or older, have held the Roth IRA for at least five years, and wish to withdraw from your account, you will not be subject to any taxes or penalties (if you’ve converted dollars into the Roth IRA, this may get more complicated). If you’re younger than 59½ and withdraw for events such as higher education expenses, a first-time home purchase, medical expenses or unexpected family events, you may be able to waive the early withdrawal penalty (but may have to pay taxes on growth), but it is advisable to speak with your tax professional beforehand to confirm your qualifications.
For those aged 59½ or older but who have had their Roth IRA for less than five years, their withdrawn earnings are subject to taxes, but not the penalty.
Is a Roth IRA Right for You?
Unlike traditional 401k plans or traditional IRAs, Roth IRAs will allow your retirement savings to grow and be withdrawn tax-free in the future. Roth IRAs can be left alone as there are no required minimum distributions (RMDs) until inherited and can be left as an inheritance or future nest egg to tap into. Because of these features, Roth accounts are generally good investment tools for people who believe their tax bracket in retirement will be higher than it is now. If you think you’ll be taxed higher in retirement, then it’s better to pay the taxes now!
With all of the various investment and saving plans available, it’s important to analyze your decisions with a financial advisor. If you are curious to see how a Roth IRA could help you reach your long-term financial goals, consider speaking to one of Personal Capital’s financial advisors — for eligible clients, they’ll offer a totally free, no-obligation portfolio review and propose a personalized financial plan for you. If you’re interested in analyzing the performance of the investments within your existing Roth IRA, you can utilize Personal Capital’s Investment Checkup Tool to evaluate your current asset allocation and level of risk in your portfolio.
Suggested next steps for you:
Talk to a financial advisor to determine if a Roth IRA is right for you.
Download Personal Capital’s FREE financial tools and run the “Investment Checkup” to analyze your current portfolio, and get suggestions on target allocations.
Read “5 Tax Hacks for Investors,” a free guide to how to make your portfolio and retirement savings more tax-efficient.