The Complete Roth IRA Guide for 2018
Comprehensive Roth IRA Guide For Your Money In 2018
Personally, I think the Roth IRA is one of the best retirement plans made available to us from Congress. The following guide will answer the questions below, going into detail on what the Roth IRA is, how it works, if you should open one, and how it can be used as part of your overall financial & retirement planning.
Chances are you have heard about the Roth IRA among other retirement accounts like a 401k, 403b, 457, or even the Roth 401k. But you probably have some questions like:
- What is a Roth IRA?
- What are the Roth IRA contribution & income limits?
- What are the Roth IRA Withdrawal Rules?
- What is a Roth IRA Conversion?
- What is a Backdoor Roth IRA?
- What is the Roth IRA Pro-Rata Rule?
- What is a Roth 401k?
- Roth IRAs for kids: Can I open a Roth IRA for my child?
- Should I open a Roth IRA?
First, a little history on the Roth IRA. The Roth IRA, as it is known today, was first established by the Taxpayer Relief Act of 1997. The Roth IRA is named by its chief sponsor, William Roth of Delaware. The idea of the Roth IRA was originally thought up by Bob Packwood of Oregon in 1989, being called the “IRA Plus”, but it never got off the ground. Since 1997 the Roth IRA has continued to gain more and more popularity, even helping promote the creation of the Roth 401k option.
What is a Roth IRA?
A Roth IRA is simply an IRA (Individual Retirement Account) that is subject to different and/or additional rules than that of a Traditional IRA. In my opinion, it is one of the best places to save money for your retirement while also getting some great tax advantages.
The IRS refers to the Roth IRA as follows; “Unlike a traditional IRA, you cannot deduct contributions to a Roth IRA. If you satisfy the requirements, qualified distributions are tax free. You can make contributions to your Roth IRA after you reach age 70½. You can leave amounts in your Roth IRA as long as you live.”
In addition to the tax-deferral advantage you are not required to take required minimum distributions (RMD) from a Roth IRA. You can leave your money in the Roth IRA as long as you live. Keep in mind that the retirement account must be designated as a Roth IRA when it is set up.
The Roth IRA is one of the most powerful tools to save for retirement. But, there are limits and rules investors must adhere to if they wish to utilize the Roth IRA.
Roth IRA Contribution & Income Limits (2018)
To be able to contribute to a Roth IRA, or even Traditional IRA, you must have “earned income”. Earned Income is income derived (earned) from active participation in a trade or business which would include things like wages, salary, tips, commissions and bonuses. If you are a stay-at-home spouse that has no earned income, but your spouse does have earned income, then you would still be eligible to contribute to an IRA. If neither of you have earned income (perhaps you are a retired couple) then neither of you would be able to contribute to any IRA.
2018 contribution limits for all of your traditional & Roth IRA’s:
- $5,500 for those under age 50
- $6,500 for those age 50 or older
- Your taxable compensation for the calendar year if it was less than these limits
These limits do not apply to any rollover contributions or qualified reservist repayments. Here is some more information on qualified reservist payments:
- If you were a member of a reserve component and you were ordered or called to active duty after 9/11/2001, you may be able to contribute (repay) to an IRA amounts equal to any qualified reservist distributions (defined under Early Distributions in Pub. 590–B) you received. You can make these repayment contributions even if they would cause your total contributions to the IRA to be more than the general limit on contributions. To be eligible to make these repayment contributions, you must have received a qualified reservist distribution from an IRA or from a section 401(k) or 403(b) plan or a similar arrangement. See Pub. 590-B under Early Distributions for more information on qualified reservist distributions.
2018 Income Limits to be able to make a Roth IRA contribution
For 2018 there are certain income limits that will determine whether or not you can even make a contribution to a Roth IRA. I will break them down by filing status and modified adjusted gross income (AGI).
How to calculate your reduced amount Roth IRA contribution
In some instances the amount you can contribute to your Roth IRA is reduced because of your modified AGI, in other words you start to get phased out. To calculate your reduced contribution, follow this IRS formula (I will show a real example just below this formula):
- Enter your modified AGI
- Subtract one of the following from the amount in (1):
- $189,000 if filing a joint return or qualifying widow(er),
- $0 if married filing a separate return and you lived with your spouse at any time in 2018, or
- $120,000 for all others
- Divide the result in (2) by $15,000 ($10,000 if filing a joint return, qualifying widow(er), or married filing a separate return and you lived with your spouse at any time during the year).
- Multiply the maximum contribution limit (before reduction by this adjustment and before reduction for any contributions to traditional IRAs) by the result in (3).
- Subtract the result in (4) from the maximum contribution limit before this reduction. The result is your reduced contribution limit.
Real Example: Okay, that is even a bit confusing for me! Here is an example, based on a married couple (ages 43 & 41) filing jointly, to show how this works.
This amount, $3,850, is the maximum you could contribute to a Roth IRA for 2018. Still unsure of what you can contribute? Use our contact form to get in touch with us and we will be happy to do the calculation for you.
Yes, these can seem a bit overwhelming. No worries, take your time to familiarize yourself with all of this. You can always ask us for guidance if you are unsure.
Roth IRA Withdrawal Rules
The IRS has a lot of rules in regard to withdrawing money from your Roth IRA. For the full rules, which are extensive, see Publication 590-B on the IRS website. I will summarize the rules for withdrawals from your Roth IRA below. Before taking a withdrawal make sure to speak with a tax professional to see how a withdrawal would affect your particular situation.
As stated on the IRS website, you will not need to include in your gross income qualified distributions that are a return of your regular contributions from your Roth IRA(s). You also do not include distributions from your Roth IRA that you roll over tax free into another Roth IRA.
The key word is qualified. Qualified distributions are defined as follows:
- It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
- The payment or distribution is:
- Made on or after the date you reach age 59½,
- Made because you are disabled,
- Made to a beneficiary or to your estate after your death, or
- One that meets the requirements for a first home (up to a $10,000 lifetime limit).
If you do not meet the qualified distribution rules then you may have to pay taxes as well as a penalty tax on the taxable portion of any Roth IRA withdrawals you make, thus the importance of working with a tax professional before making any decisions.
If you make a withdrawal that is not qualified, you may have to pay a 10% penalty tax on the early distribution. As seen on the IRS website, there are some exceptions to paying this additional tax, as listed below, otherwise you generally must pay the 10% penalty tax on the taxable part of any withdrawals that are not qualified distributions. The 10% penalty tax also applies to a non-taxable distribution if you withdraw a conversion contribution within five years following the conversion.
Exceptions to paying the additional 10% tax:
- You have reached age 59½.
- You are totally and permanently disabled.
- You are the beneficiary of a deceased IRA owner.
- You use the distribution to buy, build, or rebuild a first home.
- The distributions are part of a series of substantially equal payments made for life or life expectancy.
- You have unreimbursed medical expenses that are more than 7.5% (or 10% after 2018) for the year.
- You are paying medical insurance premiums during a period of unemployment.
- The distributions are not more than your qualified higher education expenses.
- The distribution is due to an IRS levy of the qualified plan.
- The distribution is a qualified reservist distribution.
To summarize I think it is safe to say that taking a withdrawal from your Roth IRA is based on your particular situation. Given that there are so many variables for the withdrawal calculation it is highly recommended you do so with the guidance of a tax professional.
What is a Roth IRA Conversion?
The IRS allows you to convert some or all of your traditional IRA(s) into a Roth IRA. There used to be an income cap on this but has since been removed. You can convert your traditional IRA(s) into a Roth IRA in the following ways:
- Rollover: You receive a distribution (payout) from a traditional IRA and then directly contribute it to a Roth IRA within 60 days after the distribution (the distribution check is payable to you).
- Trustee-to-trustee transfer: You instruct the financial institution currently holding your traditional IRA assets to transfer an amount (some or all) directly to the trustee of your Roth IRA at a different financial institution (the distributing trustee may achieve this by issuing you a check payable to the new trustee).
- Same trustee transfer: If your traditional and Roth IRA’s are maintained at the same financial institution, you can instruct the trustee to transfer an amount from your traditional IRA to your Roth IRA.
Some financial institutions have a simple form where you can convert a traditional IRA to a Roth IRA within the same account, simply re-characterizing it.
Keep in mind that any amounts you convert to a Roth IRA will result in taxation of any untaxed amounts (amounts you previously deducted on your taxes) in the year you convert. The conversion is reported on IRS form 8606. This is very important to remember, and we will get into this more when we discuss the pro-rata rule. Although the converted amount will be taxable to you in the year you convert, you will not have to pay the 10% IRS penalty that is usually associated with taking money out of a traditional IRA before age 59 ½.
Effective January 1, 2018, pursuant to the Tax Cuts and Jobs Act, a conversion from a Traditional, SEP or SIMPLE IRA to a Roth IRA cannot be recharacterized (reversed). The new law also prohibits recharacterizing amounts rolled over to a Roth IRA from other retirement plans, such as 401(k) or 403(b) plans.
Prior to this change in the law, if an IRA owner effected a Roth IRA conversion they had until their tax return due date, including extensions, for the year of the conversion to undo, or ‘recharacterize’ that conversion.
Under the new law all Roth conversions processed on or after January 1, 2018 are final.
While the language of the new law is not entirely clear, the IRS has announced that Roth IRA conversions done in 2017 may be recharacterized if the recharacterization is made by the tax return due date, including extensions.
What is a Backdoor Roth IRA?
The backdoor Roth IRA helps investors to essentially get around the income limits for Roth IRA contributions. Typically, investors are phased out from making a Roth IRA contribution after reaching certain income thresholds. But with a Backdoor Roth IRA, you are able to make contributions regardless of your income, thus being able to save money that now can grow tax deferred and also be taken out tax-free in the future!
Here is how to fund a Backdoor Roth IRA.
First, you make a non-deductible traditional IRA contribution. Income limits and rules still apply for this part. This also must be done before age 70 ½ since that is when you can no longer contribute to an IRA.
Second, once this non-deductible traditional IRA is open and funded, you instruct the financial institution you opened it with to help you convert it to a Roth IRA. This is usually simply done with a form they will have you sign. Typically, when you convert a traditional IRA to a Roth IRA you will have to pay taxes on the value converted. However, since you never deducted the original contribution to the traditional IRA this is a non-taxable transaction.
BUT. This is where the Pro-Rata Rule comes in. This is a very important rule that you will not want to overlook.
Some tax experts have commented on this transaction and that it may violate what is known as the “step-transaction doctrine”. But in a recent conference committee report (pages 268,269,276, and 277) by congress, the transaction was described as allowed by current law, thus legitimizing it. Ed Slot, the publisher of the IRA Advisor Newsletter, recently commented “When Congress says what its intent is, that’s it. They absolutely, clearly say it’s okay. You can make a contribution to a nondeductible IRA and convert it to a Roth IRA.”
What is the Roth IRA Pro-Rata Rule?
The pro-rata rule for Roth IRA’s is a formula used by the IRS (form 8606) to determine how much of a distribution from a Traditional, SEP, or SIMPLE IRA is taxable when the account holder has both pre-tax & after-tax dollars in their IRA’s. In calculating this amount the IRS considers all of your Traditional, SEP, and SIMPLE IRA’s as one account.
- The pro-rate rule does not apply to 401k, 403b, 457, and similar plans, only IRA’s.
The pro-rate rule only comes into play if you have made non-deductible & deductible contributions in your IRA’s. If you don’t have this situation, then no worries. Another good way to know if you the pro-rate rule applies to you is if you have had to file the IRS form 8606. If you haven’t, then you should be okay to not worry about this rule. But always confirm this with a tax professional.
But, if you do have multiple IRA’s with both pre-tax and after-tax contributions, some of which were non-deductible, then you will want to wait to convert to a Roth IRA as you may be liable for more taxes then you think.
Here is a great example when the pro-rata rule comes into play that was given by Mark O’Donnell who is the Director of Customer Education and Outreach for Employee Plans at the IRS.
“Let’s say, a client has two IRAs, one with nondeductible contributions and one with deductible contributions. The nondeductible contribution IRA has a balance of $10,000 and there are no earnings. The deductible contribution IRA has a total of $30,000 and that includes taxable earnings. When the taxpayer decides to do a conversion of the IRA that only has nondeductible contributions, $10,000, you need to determine how much of the conversion will really be taxable. Under the pro rata rule, you divide the total of the taxable amount in all of the IRAs by the total of all of the IRAs.
In this example, the taxable amount in the taxpayer’s IRAs total $30,000. You divide that by the total of all the IRAs, which is the $10,000, which is nondeductible and the $30,000, which is deductible for a total of $40,000; $30,000 divided by $40,000 equals 75%. So in this example 75% of the amount converted or $7,500 is considered taxable, even though the taxpayer thought he was only converting his nondeductible contribution.
You can look at Form 8606 and the instructions and this will explain how to determine the percentage of conversion subject to taxes.
Another thing to consider is that when an amount is converted from a traditional to a Roth IRA, the taxpayer has to complete a new beneficiary form. If the Roth IRA doesn’t have a designated beneficiary, then the Roth IRA must be distributed within five years after the account owner’s death, which would be different—the designated beneficiary would have a different distribution rule.”
I realize this is a lot to read through, but it is important, and you should know it before making any decisions.
What is a Roth 401k?
Like a traditional 401k, the Roth 401k allows you to contribute money from your pay check into an employer sponsored retirement plan. The big difference with the Roth 401k is that all of your contributions go in after-tax, unlike the pre-tax contributions into a traditional 401k. They grow tax-deferred and then you can take the entire amount out in retirement tax free.
The Roth 401k is not subject to the income & contribution limits of the Roth IRA. However, the Roth 401k is still subject to the contribution limits for 401k plans in general.
- For 2018 the max you can contribute to a Roth 401k (or regular 401k) is $18,500, plus an additional $6,000 for those employees age 50 and over.
You can contribute to both a Traditional & Roth 401k at the same time, but the max contribution between the two still cannot exceed the limits I just listed.
The Roth 401k is definitely becoming more popular for both low & high tax bracket investors. Whether you will have access to one or not is dependent on if your employer sponsored a retirement plan that had the Roth 401k option. You can always ask your HR person it if is available, and if not, ask them to add it.
A Roth 401k is certainly worth considering, but I would encourage you to speak with your tax professional to see how contributions to it versus a traditional 401k will effect your tax situation now.
Roth IRA’s for kids: Can I open a Roth IRA for my child?
Short answer, yes! But, there are still rules you must be aware of.
The IRS states that “You can contribute at any age if you (or your spouse if filing jointly) have taxable compensation and your modified adjusted gross income is below certain amounts”. Now, we already know the limits from above. If your child is working part-time, and they can prove they have earned income from wages or similar income, then they are allowed to open a Roth IRA.
It has been my experience that most financial institutions are familiar with a Roth IRA for children, but usually require a parent sign off as a custodian of the child.
But how can you open a Roth IRA for your child if they don’t have a job yet?
Maybe they are younger than 14 and not allowed to get a traditional job, what can you do then?
First, make sure you know the federal and state Department of Labor laws on child labor. They tend to vary by state but seem to be similar, with most of the laws stating that a child must be 13 or 14 before they can legally hold a job, and then only are allowed to work so many hours.
However, there are a couple exceptions to these rules.
The exception essentially states that if you own a family business that you can employ your child and pay them. Make sure to double-check the child labor laws of your particular state as some states do not allow the employment of kids under a certain age even if the federal laws do.
Now keep in mind, the IRS is very clear that you must pay your child a reasonable wage for realistic duties. For example, you couldn't pay your child $100,000 a year to water the office plants and take out the garbage! You need to make sure you keep it reasonable and realistic, otherwise you will be opening yourself up to some scrutiny from the IRS. I encourage you to consult a tax and legal professional to make sure your particular situation would allow for the employment of your child. Better to be safe than sorry!
Should I open a Roth IRA?
In my opinion, yes! But, it depends on your specific financial situation. Make sure to consult a professional to learn if one is right for you.
The Roth IRA is one of the best, and only, places you can save in a really tax advantaged way. We don’t know what the income tax rates will be many years from now but having a mix of retirement accounts that are taxed differently can give you a lot more flexibility in the future.
So, where can you open a Roth IRA? Well, most financial institutions can help you set one up. It will depend on whether you want to be a do-it-yourself investor or if you want guidance. It will also be determined by how much or how little risk you wish to take. There are options for all types of investors.
Here is my short plug.
It has been my experience that people are better equipped to decide on if and where to open a Roth IRA once they have a better handle on their overall financial situation. Working with a Certified Financial Planner® like myself and going through the financial planning process can help you answer questions regarding if you should have a Roth IRA and how it will fit into the rest of your financial situation.
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Thank you for taking the time to educate yourself with this Roth IRA guide for 2018. It is a lot to read through but hopefully you learned a few things that will help you better prepare for the future.
Wishing you all the best,