A ROTH IRA is a tax-advantaged individual retirement account to which you can contribute after-tax dollars. The primary benefit of a ROTH IRA is that your contributions and the earnings on those contributions can grow tax-free and be withdrawn tax-free after the age 59½.
There are, however, some limitations and rules when contributing to a ROTH IRA.
Earned Income - First the IRS limits what type of money can be contributed to a ROTH IRA. Basically, you can only contribute earned income or W2 funds to the Roth account. This can include wages, salaries, commissions and bonuses but does not include items such as Social Security, interest payments, or rent payments.
Contribution Limits - The IRA also controls how much you are able to contribute for 2023 ROTH contribution limits are:
● $6,500 ($7,500 if you're age 50 or older), or
● If less, your taxable compensation for the year
A ROTH IRA can be established anytime. However, contributions for a tax year must be made by the IRA owner’s tax-filing deadline, which is normally April 15 of the following year.
Income Limits - There are also income limits to whether you can contribute depending on your tax filing status. *
● Married Filing Jointly – Less than $218,000
● Single – Less than $138,000
*There is a phase out after these limits where you can contribute a reduced amount up to $228,000 for Married Filing Jointly and $153,000 for Single
If your employer offers a ROTH option within your 401(k) the contribution and income limits, follow the rules of the 401(k).
Withdrawal Limits - Lastly, the ROTH IRA five-year rule says you cannot withdraw earnings tax-free until it's been at least five years since you first contributed to a ROTH IRA account. This five-year rule applies to everyone who contributes to a Roth IRA.
If you are unable to contribute to a ROTH IRA because of the income limits or suspect you will be in a high tax bracket during retirement, you can do a ROTH conversion. A ROTH IRA conversion involves the transfer of retirement assets from a traditional-type IRA into a ROTH IRA. During this transaction, the account owner has to pay income tax on the money they convert. The following is an example:
A single individual will earn a taxable income of $80,000 in 2023, and has $100,000 in a traditional IRA that they'd like to convert into a Roth. Based on the taxable income, the highest marginal tax bracket is 22%.
Because the 22% bracket ends at $95,375, they could convert up to $15,375 this year ($95,375 minus $80,000) and pay no more than 22% tax on the money. The converted money would then go into the ROTH account.