RETIREMENT PLANNING
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Roth IRAs are often touted for their tax-advantaged retirement savings benefits, but your Roth IRA has advantages as a financial resource beyond retirement savings.
You can use a Roth IRA to help pay college expenses, to make a down payment for a home or to serve as an emergency fund. But the primary benefit of a Roth IRA is the contributions you make grow tax deferred.
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When you take a withdrawal, it’s important to consider tax restrictions for how you take money out. For example, contributions you’ve made should come out first, because they can come out any time for any reason, tax and penalty free. Conversions and rollovers you’ve made to the account should come next with the taxable portion coming out first followed by the non-taxable portion. Earnings are withdrawn last.
Earnings may be subject to tax and penalty unless the distribution meets the definition of a “qualified withdrawal.” To be a qualified withdrawal, you must have made your first contribution or conversion to the Roth IRA at least five years prior, and the distribution must meet one of these four requirements: over age 59½, disability, first time home buyer’s exception (up to $10,000), distributions to a beneficiary after your death.
For example, if you are age 50, you’ve contributed $50,000 to a Roth IRA, and you’ve earned $20,000 in investment returns, you could withdraw up to $50,000 without tax or penalty. You would be taxed and possibly subject to an early withdrawal penalty on any withdrawals beyond that unless it was a “qualified withdrawal.”
It’s also important to understand that these withdrawals are not considered loans. However, if you find that you don’t need the withdrawal, you will have 60 days from the date of the reception to roll the dollars back into the original Roth IRA or over to another Roth account under your name. You are only allowed one rollover in a 12-month period for all IRAs that you own.
Many parents set up 529 plans or Coverdell Educational Savings Accounts to help fund college costs, but there may be advantages to using a Roth IRA for the same purpose. For instance, you could withdraw your contributions (the principal), for this purpose.
In addition, if you also withdrew the earnings, you would be subject to income tax on the earnings, but the 10% early withdrawal penalty doesn’t apply because qualified higher education expense is a penalty exception. Qualified educational expenses include such costs as tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible educational institution.
However, because of the contribution limitations of a Roth IRA, you may not be able to put away enough money to cover four years of college costs. On the other hand, most 529 plans have contribution limits well more than $300,000, giving contributors the ability to cover most, if not all, of their child’s college costs.
With 529 plans, if your child doesn’t use the money for education—and you don’t have another qualified family member to transfer the 529 funds to—once you start withdrawing the funds, you would typically be responsible for paying income taxes on the investment gains within the account, and you would be assessed an additional 10% penalty tax on the earnings for using your 529 savings for non-qualified expenditures.
With a Roth IRA, if your child doesn’t need funding for higher education, you can keep the money in the account until you’re ready to withdraw it.
If you would like to buy a home, you may consider using your IRA as a source for part of the down payment. First time home buyers—defined as those who have never owned a home or have not had a financial interest in a home during the past two years—have a one-time option to withdraw up to $10,000 from an IRA to use as a down payment without penalty. Your spouse can also withdraw up to $10,000 from his or her IRA for the down payment.
Roth IRA holders can withdraw the money they’ve contributed tax and penalty-free. In addition, if it’s been at least five years since the first contribution or conversion to your Roth IRA, a distribution of earnings, up to $10,000 as a first-time home purchase, is considered a “qualified distribution” from the Roth and is not subject to tax or penalty. If it has not been five years since your first contribution to the Roth IRA, then the distribution is not a “qualified distribution” and the earnings would be subject to income tax, but not subject to the 10% early withdrawal penalty. Read Avoiding tax penalties on IRAs for details.
Since you can withdraw your contributions from your Roth IRA at any time without tax or penalty, a Roth IRA can be used as a back-up fund to cover unexpected costs, such as medical care, costly repairs and family emergencies.
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If you’re thinking of helping your children or grandchildren with education expenses, a 529 plan may be an option well worth considering.
Saving to your IRA now could make a big difference later
While many people wait until the deadline to contribute to an IRA, you could accelerate your savings process by contributing a year earlier during the current tax year instead of at the deadline in the following year.
Here are some of the most important rules and contribution limits to help you get the most out of your Roth IRA. Visit IRS.gov for more details.
Contribution limits
For the 2024 and 2025 tax years, you can contribute the lesser of $7,000 or your earned income. If you’re 50 or over, you can contribute a total of $8,000 (or up to your earned income) for 2024 and 2025. If you contribute to both a traditional and a Roth IRA, your total contributions cannot exceed your contribution limit.
Spouse contributions
Your spouse can also contribute if you have sufficient combined earned income. For instance, if you’re both under 50, you and your spouse could each contribute up to $7,000 for the 2024 and 2025 tax years if your combined earned income is at least $14,000. (If you’re both over 50, the higher limits would apply.)
Age restrictions
Roth IRAs have no age restrictions for contributions. You are not required to take withdrawals from your Roth IRA during your lifetime.
Spouse beneficiaries may conduct a spousal transfer into their own Roth IRA where they will have to follow the distribution rules as if the funds had been originally theirs. Another option is for your spouse beneficiary to open an inherited Roth IRA. They will need to start taking distributions based on their own life expectancy. A third option is to open an inherited Roth IRA using the 10-year method. No distributions are required during years one through nine, however; all money needs to be distributed by Dec. 31 of the 10th year following death. Finally, your spouse beneficiary can take a lump sum distribution that will not have contributions be taxed, nor will earnings assuming the Roth IRA was more than five years old when you (the original account owner) died.
Generally, a non-spouse beneficiary must distribute the full inherited Roth IRA by Dec. 31 of the 10th year following the year of the owner’s death.
Higher income restrictions
There are income restrictions to be eligible to contribute to a Roth IRA:
When to make contributions
Contributions can be made to your Roth IRA at any time during the calendar year, and as late as the due date for filing your tax return (which is usually on or around April 15 of the following year).
Contributions: Lump sum or throughout the year?
You can make contributions as a lump sum, or periodically. You can also set up an automatic purchase plan that withdraws a set amount of money each month from your bank account and invests it in the mutual fund or funds of your choice within your IRA account.
Conversions
Conversions are subject to penalty if withdrawn before five years since the conversion have passed and if you are under 59½.
401(k) plan
If you already have a (401k) plan or another type of retirement plan at work (such as a pension, profit-sharing SIMPLE or SEP plan), you can contribute to a Roth IRA if you are under the income ceiling.
The information provided is not intended as a source for tax, legal or accounting advice. Please consult with a legal and/or tax professional for specific information regarding your individual situation.
