By: Gene Walden, Senior Finance Editor December 20, 2018
Roth IRAs (Individual Retirement Accounts) are often touted for their tax-advantaged retirement savings benefits, but your Roth IRA can serve as a handy financial resource well beyond retirement savings.
For instance, you can use a Roth IRA to help pay college expenses for your children, to make a down payment for a home, or to serve as an emergency fund for unexpected expenses. But, of course, the primary benefit of a Roth IRA is the contributions you make, grow tax-deferred.
When you take a withdrawal, your contributions come out first, and can come out anytime for any reason, tax and penalty free. Conversions and rollovers are second with the taxable portion coming out first followed by the non-taxable portion. Earnings are withdrawn after that. The taxable portion of your distribution may be subject to tax and penalty, unless the distribution meets the definition of a “qualified withdrawal.” In order to be a qualified withdrawal, you must have had a Roth IRA for at least five years and the distribution must be meet one of these four requirements: 1) You are over age 59 ½, 2) Disability, 3) First time home buyer’s exception or 4) Distributions to a beneficiary after your death. Learn more about qualified withdrawals.
For example, if you are age 50, you’ve contributed $50,000 to a Roth IRA, and you’ve earned $20,000 in investment returns, you could withdraw up to $50,000 without tax or penalty. You would be taxed and possibly subject to an early withdrawal penalty on any withdrawals beyond that, unless it was a “qualified withdrawal.”
It’s also important to understand that these withdrawals are not considered loans. However, if you find that you don’t need the withdrawal, you would have 60 days from the date of the distribution to roll the dollars back into the original Roth IRA or over to another Roth account under your name. You are only allowed one rollover in a 12 month period for all IRAs that you own.
While a traditional IRA also offers tax-deferred growth within the account, there are some important differences between traditional and Roth IRAs.
The biggest difference is in the tax treatment of contributions and distributions. With a traditional IRA, contributions may be tax-deductible from your income for the current tax year – thus typically lowering your current year’s taxes – but your distributions would generally be taxable in retirement.
By contrast, Roth IRA contributions are made with after-tax dollars and would not be deductible on your current year’s taxes. But, as noted, your qualified withdrawals would be tax-free. Typically, the money would grow tax-deferred in your account and be withdrawn tax-free in retirement.
In addition to its retirement savings benefits, a Roth IRA can also be used to help fund some of life’s other financial milestones:
Many parents set up 529 or Coverdell Educational Savings plans to help fund their children’s college costs, but there may be some advantages to using a Roth IRA for the same purpose. For instance, you could withdraw your contributions (the principal), for this purpose. In addition, if you also withdrew the earnings you would be subject to income tax on the earnings, but the 10% early withdrawal penalty doesn’t apply because qualified higher education expense is a penalty exception. Qualified educational expenses include such costs as tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution.
However, because of the contribution limitations of a Roth IRA, you may not be able to put away enough money to cover four years of college costs. On the other hand, most 529 plans have contribution limits well in excess of $300,000, giving contributors the ability to cover most, if not all, of their child’s college costs. (See: How to Choose a 529 Educational Savings Plan)
With 529 plans, if your child doesn’t use the money for education – and you don’t have another qualified family member to transfer the 529 funds to – once you start withdrawing the funds, you would typically be responsible for paying income taxes on the investment gains within the account, and you would be assessed an additional 10% penalty tax for using your 529 savings for non-qualified expenditures.
With a Roth IRA, if your child doesn’t need funding for higher education, you can keep the money in the account until you’re ready to withdraw it.
Buying a home
If you would like to buy a home, you may consider using your IRA as a source for part of the down payment. First time home buyers – defined as those who have never owned a home or have not had a financial interest in a home during the past two years – have a one-time option to withdraw up to $10,000 from an IRA to use as a down payment without penalty. Your spouse can also withdraw up to $10,000 from his or her IRA for the down payment.
The rule applies to both Roth IRAs and traditional IRAs, although there are differences in how the rule applies. While both types of IRAs may be used without being subject to the 10% early withdrawal penalty tax, traditional IRA holders would have to pay income taxes on the withdrawal.
Roth IRA holders can withdraw the money they’ve contributed tax and penalty-free. In addition, if it’s been at least five years since the Roth IRA was established, a distribution of earnings, up to $10,000 as a first time home purchase, is considered a “qualified distribution” from the Roth and is not subject to tax or penalty. If it has not been five years since you established a Roth IRA, then the distribution is not a “qualified distribution” and the earnings would be subject to income tax, but not subject to the 10% early withdrawal penalty. Read Avoiding Tax Penalties on IRAs for details.
Since you are able to withdraw your contributions from your Roth IRA at any time without tax or penalty, a Roth IRA can be used as a back-up fund to cover unexpected costs, such as medical care, costly repairs, and family emergencies.
Roth IRA Contribution Rules and Limits
Here are some of the most important rules and contribution limits to help you get the most out of your Roth IRA. Visit IRS.gov for more details.
How much can I contribute?
The Roth and traditional IRAs have the same contribution limits. For the 2018 tax year, you can annually contribute the lesser of $5,500 or your earned income. If you’re 50 or over, you can contribute a total of $6,500. For 2019, you can contribute the lesser of $6,000 or your earned income. If you’re 50 or over, you can contribute a total of $7,000 (or up to your earned income). If you contribute to both a traditional and a Roth IRA, your total contributions cannot exceed your contribution limit.
Can my spouse contribute?
Your spouse can also contribute as long as you have sufficient combined earned income. For instance, if you’re both under 50, you and your spouse could each contribute up to $5,500 annually ($6,000 for the 2019 tax year) if your combined earned income is at least $11,000 (or $12,000 for 2019). (If you’re both over 50, the higher limits would apply.)
Are there age restrictions?
There are no age limitations for a Roth IRA. With a traditional IRA, you must stop making contributions the year that you reach age 70 ½; there are no such restrictions with a Roth IRA. You can contribute for your entire life, as long as you or your spouse has earned income sufficient to match your contribution. And you are not required to take withdrawals from your Roth IRA during your lifetime. Although your beneficiaries are subject to Required Minimum Distributions, they would typically be tax-free, if a “qualified withdrawal.”
Are there upper income restrictions?
There are upper income restrictions to be eligible to contribute to a Roth IRA – unlike a traditional IRA, which carries no upper income limitations.
For a Roth IRA, single filers must have a Modified Adjusted Gross Income under $135,000 for tax year 2018 and under $137,000 for the tax year 2019. Contributions would be reduced on a sliding scale with Modified Adjusted Gross Income between $120,000 and $135,000 in 2018 and between $122,000 and $137,000 for 2019.
Married couples filing jointly must have Modified Adjusted Gross income under $199,000 for tax year 2018 and under $203,000 for 2019. Contributions would be reduced on a sliding scale with Modified Adjusted Gross income between $189,000 and $199,000 in 2018 and between $193,000 and $203,000 in 2019.
See more details on Roth IRA income restrictions.
When should I make contributions?
Contributions can be made to your Roth or traditional IRAs at any time during the calendar year, and as late as the due date for filing your tax return (which is usually on or around April 15 of the following year). (See: Contributing Earlier to Your IRA Can Make a Big Difference Over Time)
Do I have to contribute one lump sum or can I contribute throughout the year?
You can make contributions as a lump sum, or periodically. You can also set up an automatic monthly contribution plan that withdraws a set amount of money each month from your savings account and invests it in the mutual fund or funds of your choice within your IRA account.
What if I have a 401k plan at work?
If you already have a 401k plan or another type of retirement plan at work (such as a pension, profit-sharing SIMPLE or SEP plan), you may be able to contribute to a Roth IRA if you are under the income ceiling or a traditional IRA (deductibility may be limited).
At Thrivent Mutual Funds, we recommend you consult your tax advisor to make sure you’re getting the most out of your investments. Thrivent Mutual Funds and their representatives cannot provide legal or tax advice.