The Roth IRA, for good reason, is widely praised for its tax-free nature. Once you've put money into a Roth and meet the requirements, you'll never have to worry about tax again -- ever.
However, as with anything free, there is at least one catch; in the case of Roth IRAs, there are several. You'll need to be up to date on current tax law to ensure you're making these contributions within legal guidelines. Once money is in your Roth, you can look forward to a long road of growth-sans-tax, and what will hopefully amount to a very valuable asset once it's come time to retire.
Below you'll find four helpful points to review before contributing to a Roth.
1. To contribute to a Roth, you need to earn (some) money
Current law requires Roth IRA contributors to have earned income for the year. This money doesn't need to come from a full-time job or stable source, but it does have to be the fruit of your labor -- it cannot be portfolio income or Social Security payments. You also are not able to contribute more than you earn -- for example, if you made $3,000, you would be limited to a $3,000 Roth contribution.
If one spouse works a full-time job and the other does not, as long as the working spouse earns $12,000 and MAGI is below the defined limit, they would both be able to contribute the maximum amount to separate Roth IRAs. If both spouses are over 50, the working spouse would need to earn at least $14,000 and each spouse would be able to contribute $7,000 to an individual Roth account.
2. There are income phaseouts for Roth contributions
Roth IRA contributions (limited at $6,000 for 2020, $7,000 for individuals over 50) begin to phase out for single taxpayers at $124,000 of MAGI (Modified Adjusted Growth Income) and for married couples at $196,000 of MAGI. Furthermore, single taxpayers earning above $139,000 and married couples earning over $206,000 are ineligible to contribute. Note that MAGI levels in between these boundaries allow the taxpayer(s) to contribute an intermediate amount.
Couples earning well over $200,000 cannot simply take $12,000 and contribute to two separate Roth IRAs, but they do have some recourse -- a Backdoor Roth contribution is needed if the couple wants to put money in their Roth IRAs this year. A Backdoor Roth contribution entails directing money to a Traditional IRA first, and then converting that money to a Roth IRA to systematically (but legally) avoid taxation. This sounds complicated -- it's not -- and is worth briefly studying for the long-term tax advantage.
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3. You may need to pick a tax year for your contribution
Many people contributing to Roth IRAs make monthly contributions to their accounts throughout the tax year. This is a perfectly fine strategy, but the optimal route with regard to making Roth contributions is to contribute the maximum as early on in the calendar year as possible. If you have the cash available -- or can make it available -- it's generally best to make a direct Roth contribution or conduct a Backdoor Roth contribution in early January. This gives your money the most time to grow unencumbered by any sort of tax.
However, if you can't get it done that quickly, you may have more time than you might think to contribute to your Roth IRA. You have the ability to contribute to your Roth up to April 15th of the following year, and the contribution will still count for the previous year. For example, if you discover the Roth IRA in February of Year 2, you can still max out your Roth IRA for Year 1 as long as you do so by tax day. This allows you to max out contributions for both years, depending on your specific circumstances and your ability to fund the account.
4. Make your Roth part of your overall financial plan
Before making a Roth contribution -- and in most cases, you really should -- be careful to ensure that the account and the investments held within are in line with a broader financial plan. A comprehensive plan looks at all accounts -- tax-deferred, tax-free, and taxable -- and considers the holistic effect(s) of each financial transaction on your wider portfolio. Net worth is driven by total portfolio performance, which looks at all accounts taken as a whole. This helps to avoid mental accounting, or designating specific accounts for specific goals, which has been shown to yield suboptimal results.
Roth IRAs can be an especially useful planning tool and have many outstanding benefits for those who contribute annually. The rules tend to be slightly muddy at the time of deposit, but the benefits of the account are often felt for decades into the future. It's imperative for those interested in growing tax-free money to learn about and take advantage of Roth accounts.
