By Frances Coppola | American Express Credit Intel Freelance Contributor
9 Min Read | July 31, 2020 in Money
Roth IRAs let you save for retirement with post-tax dollars, so everything you withdraw after you retire will be tax-free.
Unlike Traditional IRAs, Roth IRAs have income-based contribution limits.
If you accidentally exceed your yearly Roth IRA contribution limit, the IRS will tax the excess amount.
There are many ways to save for retirement, each with different benefits and limitations. Many people are familiar with traditional IRAs, which let you save for retirement tax-free. Fewer, though, are aware of Roth IRAs, which may be an attractive alternative to a traditional IRA depending on your situation and your needs. But there’s a catch: Roth IRA contribution limits. Not everyone can save in a Roth IRA. Your eligibility to contribute, as well as the amount you can contribute each year if you are eligible, depends on your income.
To help you decide whether a Roth IRA makes sense for you, I’ll discuss the following:
Both a traditional Individual Retirement Arrangement (IRA) and a Roth IRA provide tax relief. The difference is when that relief applies:
Roth IRAs might sound like a good deal, but it depends on your personal circumstances. Many financial planners advise young people to save as much as they can afford in Roth IRAs, before their income rises above the contribution limit. Generally, because the more you earn the more tax you pay, if you expect your income will be higher in retirement than during your working life, then paying the tax up front with a Roth IRA can mean a lower total tax bill over your lifetime. Alternatively, if you are unsure about your retirement tax status, it can be helpful to diversify with both taxed investment and savings accounts and tax deferred. For example, if you have a tax-deferred 401(k) through your employer, which will incur tax when you draw from it in retirement, you could include a Roth IRA in your retirement planning so that you will be able to take some of your retirement income tax free.1
Three other differences between traditional and Roth IRAs result from the different initial tax treatment:
So, if you are still working in your seventies, or you have income from other sources that you want to reinvest, a Roth IRA could be a good choice.
Income limits on Roth IRA contributions exist because the tax advantages of IRA accounts are meant to benefit average American workers. Income limits prevent highly paid people from benefiting more than the average person, or family.2 For tax-year 2020, income limits on Roth IRA contributions begin to kick in at:
If you earn above those income limits, the amount you can contribute to a Roth IRA gradually tapers off according to a formula described below. The accompanying table shows how Roth IRA contributions taper off as your income rises. In 2020, if your income is at or above the maximum – $139,000 if you’re single, $206,000 if you’re married3 – you won’t be able to contribute to a Roth IRA, though you can still use a traditional IRA. Two more key points are worth noting about Roth IRA income limits:
2020 Income Limits for Roth IRA Contributions
|2020 Income||Contribution Limit|
|Single, head of household, and married people filing taxes separately but not living together||Below $124,000
|$124,000 to $138,999||Variable depending on income level|
|$139,000 and above||Zero|
|Married people living together but filing taxes separately||Below $10,000||Variable depending on income level|
|$10,000 and above||Zero|
|Married people filing taxes jointly, and qualifying widows & widowers||Below $196,000||Maximum|
|$196,000 to $205,999||Variable depending on income level|
The chart shows, for example, that a single person whose income is under $124,000 can contribute the maximum amount to their Roth IRA.
For 2019 and 2020, the maximum you can contribute to a Roth IRA (or a traditional IRA) is $6,000 ($7,000 if you are over 50).4
That’s a combined maximum, across all your IRA accounts. It’s up to you to decide how you want to split your contributions within that limit: you could, for example, put $3,000 into each account, or you could opt to contribute more to one account than the other. You can’t contribute more than you earn, so if you earn less than the Roth IRA contribution limit for your age, your Roth IRA contribution limit is effectively your total income.
To figure out your Roth IRA contribution limit, you first need to calculate your modified adjusted gross income (MAGI), not taxable income. MAGI is essentially your adjusted gross income (AGI) with certain adjustments added back in. Which adjustments you add back are different depending on the tax purpose involved. For calculating Roth IRA contribution limits, you’ll add back any of the following that apply to you:
In practice, there may be little difference between AGI and MAGI for many people.
Once you have your MAGI, these four steps constitute the formula for calculating your Roth IRA contribution limit:
Next, let’s plug numbers into the formula to show how it works. Suppose you are a single person younger than 50 with a MAGI of $130,000. Here’s the formula in action:
So, in the example above, $3,600 is the maximum you can contribute to a Roth IRA in 2020 if you’re single and earn $130,000. As this shows, however, calculating MAGI and Roth IRA contribution limits can be complex, so it may be wise to seek advice from a professional tax adviser.
It can be easy to exceed your Roth IRA contribution limit. It might be because your income for the year was higher than you expected, so your contribution limit was lower; or, at the opposite end of the scale, you earned less than the amount you put into your Roth IRA. Or perhaps you simply lost track of how much you had contributed over the year.
If you accidentally pay more into your Roth IRA than your contribution limit, the government will tax the excess amount at 6% each year as long as it remains in the account. To avoid the tax, you can withdraw the excess amount along with any earnings, though if you are under 59½ or have held the Roth IRA for less than 5 years you will pay a penalty. You may also have to pay tax on any earnings from the excess amount.6
A Roth IRA can be an attractive way of saving for retirement. However, the rules are complex, and it may not be suitable for everyone. When making major saving and retirement planning decisions, it’s always wise to consult a professional tax adviser.
1 “Ultimate Guide to Retirement,” CNN Money
2 “Why IRA, Roth IRA, and 401(k) Contributions Are Limited,” Investopedia
6 “What Happens If I Go Over My IRA Contribution Limit?,” Merrill