Are Roth IRAs Insured?
If your account is located at a bank, be aware IRAs fall under a different insurance category than conventional deposit accounts. Therefore, coverage for IRA accounts is not as robust. The Federal Deposit Insurance Corporation (FDIC) still offers insurance protection up to $250,000 for traditional or Roth IRA accounts, but account balances are combined rather than viewed individually.910
For example, if the same banking customer has a certificate of deposit held within a traditional IRA with a value of $200,000 and a Roth IRA held in a savings account with a value of $100,000 at the same institution, the account holder has $50,000 of vulnerable assets without FDIC coverage.
What Can You Contribute to a Roth IRA?
The IRS dictates not only how much money you can deposit in a Roth, but the type of money you can deposit. Basically, you can only contribute earned income to a Roth IRA.
For individuals working for an employer, compensation that is eligible to fund a Roth IRA includes wages, salaries, commissions, bonuses, and other amounts paid to the individual for the services they perform. It’s generally any amount shown in Box 1 of the individual’s Form W-2. For a self-employed individual or a partner in a partnership, compensation is the individual’s net earnings from their business, less any deduction allowed for contributions made to retirement plans on the individual’s behalf and further reduced by 50% of the individual’s self-employment taxes.
Money related to divorce—alimony, child support, or in a settlement—can also be contributed.
So what sort of funds aren’t eligible? The list includes:
- Rental income or other profits from property maintenance
- Interest income
- Pension or annuity income
- Stock dividends and capital gains
You can never contribute more to your IRA than you earned in that tax year. And, as previously mentioned, you receive no tax deduction for the contribution—although you may be able to take a Saver’s Tax Credit of 10%, 20%, or 50% of the deposit, depending on your income and life situation.
Who’s Eligible for a Roth IRA?
Anyone who has taxable income can contribute to a Roth IRA—as long as they meet certain requirements concerning filing status and modified adjusted gross income (MAGI). Those whose annual income is above a certain amount, which the IRS adjusts periodically, become ineligible to contribute.4 The chart below shows the figures for 2020 and 2021.
| Do You Qualify for a Roth? | ||
|---|---|---|
| Category | Income Range for 2020 Contribution | Income Range for 2021 Contribution |
| Married and filing a joint tax return | Full: Less than $196,000 Partial: From $196,000 to less than $206,000 |
Full: Less than $198,000 Partial: From $198,000 to less than $208,000 |
| Married, filing a separate tax return, lived with spouse at any time during the year | Full: $0 Partial: Less than $10,000 |
Full: $0 Partial: Less than $10,000 |
| Single, head of household, or married filing separately without living with spouse at any time during the year | Full: Less than $124,000 Partial: From $124,000 to less than $139,000 |
Full: Less than $125,000 Partial: From $125,000 to less than $140,000 |
These individuals must use a formula to determine the maximum amount they may contribute to a Roth IRA. An individual who earns less than the ranges shown for his or her appropriate category can contribute up to 100% of his or her compensation or the contribution limit, whichever is less.
Individuals within the phase-out range must subtract their income from the maximum level and then divide that by the phase-out range to determine the percentage of $6,000 they are allowed to contribute.
The Spousal Roth IRA
One way a couple can boost their contributions: the spousal Roth IRA. An individual may fund a Roth IRA on behalf of their married partner who earns little or no income. Spousal Roth IRA contributions are subject to the same rules and limits as regular Roth IRA contributions. The spousal Roth IRA must be held separately from the Roth IRA of the individual making the contribution, as Roth IRAs cannot be joint accounts.
For an individual to be eligible to make a spousal Roth IRA contribution, the following requirements must be met:
- The couple must be married and file a joint tax return.
- The individual making the spousal Roth IRA contribution must have eligible compensation.
- The total contribution for both spouses must not exceed the taxable compensation reported on their joint tax return.
- Contributions to one Roth IRA cannot exceed the contribution limits for one IRA (however, the two accounts allow the family to double their annual savings).
Withdrawals: Qualified Distributions
At any time, you may withdraw contributions from your Roth IRA, both tax- and penalty-free. If you take out only an amount equal to the sum you’ve put in, the distribution is not considered taxable income and is not subject to penalty, regardless of your age or how long it has been in the account. In IRS-speak, this is known as a qualified distribution.
However, there’s a catch when it comes to withdrawing account earnings—any returns the account has generated. For distribution of account earnings to be qualified, it must occur at least five years after the Roth IRA owner established and funded his/her first Roth IRA, and the distribution must occur under at least one of the following conditions:
- The Roth IRA holder is at least age 59½ when the distribution occurs.
- The distributed assets are used toward the purchase—or to build or rebuild—a first home for the Roth IRA holder or a qualified family member (the IRA owner’s spouse, a child of the IRA owner or of the IRA owner’s spouse, a grandchild of the IRA owner and/or of their spouse, a parent or other ancestor of the IRA owner or of their spouse). This is limited to $10,000 per lifetime.
- The distribution occurs after the Roth IRA holder becomes disabled.
- The assets are distributed to the beneficiary of the Roth IRA holder after the Roth IRA holder’s death.
The 5-Year Rule
Withdrawal of earnings may be subject to taxes and/or a 10% penalty, depending on your age and whether you’ve met the 5-year rule.
Here’s a quick rundown.
If you meet the 5-year rule:
- Under 59½: Earnings are subject to taxes and penalties. You may be able to avoid taxes and penalties if you use the money for a first-time home purchase (a $10,000-lifetime limit applies), if you have a permanent disability, or if you pass away (and your beneficiary takes the distribution).
- Age 59½ and older: No taxes or penalties.
If you don’t meet the 5-year rule:
- Under 59½: Earnings are subject to taxes and penalties. You may be able to avoid the penalty (but not the taxes) if you use the money for a first-time home purchase (a $10,000-lifetime limit applies), qualified education expenses, unreimbursed medical expenses, if you have a permanent disability, or if you pass away (and your beneficiary takes the distribution).
- 59½ and older: Earnings are subject to taxes but not penalties.
Roth withdrawals are made on a FIFO basis (first in, first out)—so any withdrawals made come from contributions first. Therefore, no earnings are considered touched until all contributions have been taken out first.
Withdrawals: Non-Qualified Distributions
A withdrawal of earnings that do not meet the above requirements is considered a non-qualified distribution and may be subject to income tax and/or a 10% early-distribution penalty. There may be exceptions, however, if the funds are used:
- For unreimbursed medical expenses. If the distribution is used to pay unreimbursed medical expenses for amounts that exceed 10% of the individual’s adjusted gross income (AGI) for the year of the distribution. (That 10% number applies to withdrawals after 2012. Prior to that, it was 7.5% of the AGI.)
- To pay medical insurance. If the individual has lost his or her job.
- For qualified higher-education expenses. If the distribution goes toward qualified higher-education expenses of the Roth IRA owner and/or his or her dependents. These qualified education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution and must be used in the year of the withdrawal.
- For childbirth or adoption expenses. Up to $5,000, if made within one year of the event.
Note that if you withdraw only the amount of your contributions made within the current tax year—including any earnings on those contributions—the contribution is reversed. For example, If you contribute $5,000 in the current year and those funds generate $500 in earnings, you can withdraw the $5,000 principal tax-free and penalty-free and the $500 gain will be treated as taxable income.
Roth IRA vs. Traditional IRA
Whether or not a Roth IRA is more beneficial than a traditional IRA depends on the tax bracket of the filer, the expected tax rate at retirement, and personal preference.
Individuals who expect to be in a higher tax bracket once they retire may find the Roth IRA more advantageous since the total tax avoided in retirement will be greater than the income tax paid in the present. Therefore, younger and lower-income workers may benefit the most from the Roth IRA. Indeed, by beginning to save with an IRA early in life, investors make the most of the snowballing effect of compound interest: Your investment and its earnings are reinvested and generate more earnings, which are reinvested, and so on.
Consider opening a Roth over a traditional IRA if you are more interested in tax-free income when you retire than in a tax deduction now when you contribute.
Of course, even if you expect to have a lower tax rate in retirement, you’ll still enjoy a tax-free income stream from your Roth. Not the worst idea in the world.
Those who don’t need their Roth IRA assets in retirement can leave the money to accrue indefinitely and pass the assets to heirs tax-free upon death. Even better, while the beneficiary must take distributions from an inherited IRA, they can stretch out tax deferral by taking distributions for a decade and, in some specialized cases, for their lifetimes.16 Traditional IRA beneficiaries, on the other hand, do pay taxes on the distributions. Also, a spouse can roll over an inherited IRA into a new account and not have to begin taking distributions until age 72.
Some open or convert to Roth IRAs because they fear an increase in taxes in the future, and this account allows them to lock in the current tax rates on the balance of their conversions. Executives and other highly compensated employees who are able to contribute to a Roth retirement plan through their employers [for example, a Roth 401(k)] can also roll these plans into Roth IRAs with no tax consequence and then escape having to take mandatory minimum distributions when they turn 72.