A Roth IRA is a terrific vehicle to use for retirement savings as long as you know the rules. Unlike 401(k) or traditional IRA plans, taxes are paid upfront on Roth IRA contributions and your earnings grow tax-free. If you think taxes will be higher in the future, a Roth IRA is a savings vehicle for you. But Roth IRAs have a few additional advantages over their counterparts that you might not be aware of.
The federal government knows Roth IRAs are a great deal and bans high salary employees from contributing to them. They also place limits on annual contribution amounts. These limits for contributions are released each year, but the IRA is leaving contributions limits unchanged from 2019. You’ll still get to contribute $6,000 to a Roth or $7,000 if you’re 50 or older. But the salary limits have changed, so you’ll need to familiarize yourself with the table below.
Roth IRA Contribution Limits
If you make too much money, you won’t be eligible for a Roth IRA. However, traditional IRAs have no income limits, so consider going the traditional route if you’re a high earner.
| Status | 2020 Modified AGI | Contribution Eligibility |
|---|---|---|
| Single or married filing separately (didn’t live with spouse) | Less than $124,000 | Full $6,000 contribution ($7,000 if over age 50) |
| $124,000–$139,000 | Partial contribution | |
| Over $139,000 | Ineligible to contribute | |
| Married filing jointly | Less than $196,000 | Full $6,000 contribution |
| $196,000–$206,000 | Partial contribution | |
| Over $206,000 | Ineligible to contribute | |
| Married filing separately (but lived with spouse) | Less than $10,000 | Partial contribution |
| Over $10,000 | Ineligible to contribute |
If you’re eligible for a Roth IRA, it’s a good idea to open one. Roth IRAs have some very favorable rules for savers that aren’t found with other accounts. In addition to investments growing tax-free, Roth IRAs have no mandatory distribution age and contributions can be withdrawn at any time. However, investment earnings must remain in the account; only the initial contributions can be withdrawn.
Earned Income Rule
Retirement savers can sock $6,000 per year into a Roth IRA, but that comes with an exception. To save $6,000, you need to earn $6,000 — and that doesn’t include investment or rental property earnings. To meet the earned income rule, you need taxable compensation. This includes wages, tips, commissions, bonuses and even long-term disability benefits.
Not counting as earned income would be compensation like pensions, social security, interest, dividends, and certain benefits like unemployment and alimony.
If you earned below the maximum contribution limit, you can only put what you earned into an IRA. For example, if you worked part-time and earned $4,800 in earned income, your IRA contribution limit would be $4,800.
Should You Contribute to a Roth IRA or Traditional IRA?
Roth IRAs are superior to traditional IRAs, especially if you’re already contributing to a 401(k) plan at work. By using a Roth IRA in conjunction with a 401(k), you’ll give yourself tax diversification, more control over your investments, and access to funds should you need them in an emergency.
If your modified AGI is more than $139,000 ($206,000 if married and filing separately), you won’t be able to open a Roth IRA. You can contribute the full $6,000 to a traditional IRA regardless of your income, but tax deductions on traditional IRAs are phased out if you have a 401(k) and high salary.
Here’s the bottom line: Both vehicles provide great tax savings, but the Roth IRA is the better option for most people. Income taxes are likely to rise in the coming decades and many savers prefer to pay taxes now and let their investments grow tax-free. Additionally, the Roth IRA doesn’t have a mandatory distribution age, so retirement savings can be passed down to heirs without penalty or taxation. And, a Roth IRA lets you withdrawal contributions for any reason at any time, creating a de facto emergency fund. Traditional IRAs only allow early withdrawals for qualified expenses like a first time home purchase, significant medical bills or higher education costs.
What If You Want to Contribute Past the Limit?
Want to contribute more than $6,000 to an IRA? Sorry, no can do. The $6,000 limit is a hard cap on all IRA contributions and the IRS will hit you hard if you contribute over the limit. That goes for Roth IRAs and traditional IRAs combined — you can open both types of accounts, but total contributions might remain at $6,000 or below. Since most retirement savers already have a 401(k), the Roth IRA is the vehicle of choice.
Other types of tax-sheltered accounts do exist if you’d like to put away some extra cash. But maxing out your 401(k) and Roth IRA should be your first order of business. That’s $25,500 in tax-deferred savings! If you want to save cash beyond this level while still reaping tax benefits, here are some accounts to look into.
- Health savings accounts (HSA): If you meet certain qualifications regarding health insurance deductibles, you can contribute to an HSA and get the same tax benefits as a 401(k) or traditional IRA. HSAs are funded with pre-tax dollars and the 2020 limit is $3,700 for individuals or $7,100 for families.
- 529 or Coverdell plans: If you plan to save for your children’s college expenses, consider a 529 or Coverdell plan. These plans have very high contribution limits (up $300,000 depending on your state) and provide tax-free investment growth. But like HSAs, these plans must be used on qualified education expenses like college tuition or private K-12 schooling.
Self-employed individuals can also open a Simplified Employee Pension (SEP) IRA, which allows contributions up to 25% of income or $56,000, whichever is less.
How to Find a Roth IRA that Works for You
Opening a Roth IRA is simple and painless. Nearly all online and traditional brokerage houses offer them and it’s completely free to set up and fund. No minimum contribution exists for opening one. Roth IRAs offer a wide range of investment options too, far surpassing the limited options in your 401(k). In fact, some IRAs even allow you to trade options in the account.
If you want to trade actively in your Roth IRA, consider a direct access broker like Interactive Brokers or a commission-free firm like Fidelity or Charles Schwab. If you’re looking for passive investments and want a hands-off approach, consider robo-advisors like Betterment or Wealthfront. And if you want to completely take risk off the table, open an IRA at your local bank and fill it with government-protected assets like CDs.
About Dan Schmidt
Dan has written about a wide range of topics including stocks and investing, cryptocurrencies, banking, student loans, and credit cards.