Roth IRA Eligibility: What You Need to Know

A Roth IRA is probably one of the most powerful investment vehicles for retirement, especially if you want to protect thousands of dollars from taxes.

The bad news is, however, not everyone will qualify. You have to meet certain income requirements in order to be eligible to contribute to a Roth.

For a single person, your Modified Adjusted Gross Income (MAGI) must be under $139,000. And if you’re married and filling jointly, your MAGI must be under $206,000.

If, however, you are able to contribute to a Roth, I would absolutely take advantage of it. A Roth has got some great benefits.

Benefits of a Roth IRA

One of the greatest things about a Roth is the tax benefits.

Whether you contribute to a Roth IRA, Traditional IRA, or company 401(k), you have some tax benefits to take advantage of. But nothing as great as the Roth, in my opinion.

Tax-deferred vs tax-free

A Traditional IRA or company 401(k) allows you to make tax-deferred contributions – which means that you defer (or forego) paying taxes on that income until you start withdrawing it.

A Roth, however, allows you to make tax-free contributions – basically because you’ve already paid taxes on that income. But what’s really nice, is that you won’t pay any taxes when it’s time to withdrawal, either (tax-free).

So, you pay no taxes on the growth – which is huge!

This can easily amount to saving hundreds of thousands of dollars, if not millions of dollars, in taxes.

Here’s how it works.

$40k example

Let’s say you make $40,000 a year, and you want to see whether a Roth IRA or a company 401(k)/Traditional IRA is a better way to go.

Let’s figure the numbers for the Traditional IRA/401(k) first.

On those options, you pay no taxes on the amount contributed towards retirement. So if you contribute $6,000 a year, you only have to pay taxes on $34,000.

Basically, you reduce your taxable income by $6,000 a year – easy enough.

If your tax rate is 15%, that’s $5,100 a year on $34,000.

Over the course of 40 years, that’s a total of $204,000 paid in taxes.

At retirement, you would have $5.8M (assuming a 12% return). But you would still have to pay taxes on that amount.

Assuming you have the same tax rate of 15% at retirement, you would have to pay $870,000 in taxes.

Here’s the verdict:

$5.8M – $870k = $4.9M at retirement.

Now, let’s figure those numbers on a Roth.

On a Roth, you will pay taxes on all your income at 15% – that’s $6,000 a year on $40,000.

Over the course of 40 years, you will have paid a total of $240,000 in taxes ($36k more than you would have on the a Traditional option).

At retirement, you will still have $5.8M. But you won’t have to pay taxes on any of it!

But remember – you did have to pay $36,000 more to get here, so let’s figure that in to be fair.

Here’s the verdict:

$5.8M – $36k = $5.76M at retirement.

The Roth IRA is the clear winner! When you run the numbers on a $40,000 income, the Roth IRA makes more sense than a Traditional IRA or 401(k) because of the potential hundreds of thousands of dollars you will save in taxes.

Related: How to Get a Good Return on Investment

How to start a Roth IRA

Starting a Roth IRA is easy! All you have to do is have earned income, and you can open one up online in only a few minutes.

One of my favorite online sites for this is Vanguard. Their low-cost options make it hard to pass up.

When you open a Roth IRA, you will be asked which fund (or funds) you’d like to invest in.

I would recommend one good fund to start with. A good one to consider is Vanguard’s Total Stock Market Index Fund, know as the VTSAX.

I like this fund a lot! In fact, I’ve even written about it in the past.

Related: Why the Vanguard VTSAX Fund Is All You Need

What I like about this fund is that it’s an index fund. Index funds are going to be very cheap options that don’t require a lot of management – which is why they are cheaper. Lower management mutual funds are able to keep costs extremely low. You really can’t beat it!

Index funds follow an index. In the case of the VTSAX, it follows an index that performs very similar to what the overall stock market does.

Another index you may have heard of is the S&P 500 – same thing. Funds that follow this kind of performance are usually called “total stock market” or “500 index” funds – or something like that.

The VTSAX is one of those funds. It follows the performance of what the overall stock market is doing. When you compare it to the S&P 500, they are almost identical.

VTSAX vs S&P 500

Index funds are great options to get started because they will give you full exposure to the stock market, while keeping costs low, and getting you similar returns as the overall market.

Speaking of returns, the S&P 500 has averaged an annual rate of return of about 10% since it began in the 1920s. However, it has average around 12% when you look at various 30-40 year periods.

That is extremely helpful. Although past performance doesn’t guarantee future performance, it is a nice gauge to go by.

You should be investing in funds that are performing as good as, or better than, the overall stock market – or what the S&P 500 has done.

That said, there are many funds out there that can beat the S&P 500! By adding those funds to a solid fund like the VTSAX, it will give you even more diversification and could even result in returns better than 12%.

For example, here is a growth index fund that Vanguard offers. It’s called the VIGAX. Notice how it is doing slightly better than the S&P 500.

Growth index fund vs S&P 500

So, it’s certainly possible to find funds that can beat the overall stock market, which could give you returns over the 12% average.

But, even if you get returns in the 10% to 12% range, that’s still pretty solid.

Remember the $40k example above? I used this retirement calculator to figure those numbers, and I assumed a 12% return over 40 years, investing $500 a month. That’s how I got the 5.8 million dollars from earlier.

Related: Best Vanguard Funds for a Roth IRA

How much can you contribute to a Roth IRA?

As sweet as a Roth IRA is, there are some restrictions (like any retirement account).

At the time of this writing, you are only allowed to contribute up to $6,000 a year (or $7,000 a year if over 50) towards a Roth (or Traditional).

That is $500 a month, which is exactly the amount I assumed when I used the $40k example above.

Keep in mind that this amount will likely go up overtime, as the cost of living goes up (so those numbers might even be more conservative than you think).

When I first opened my Roth several years ago, I was only able to contribute $5,000 a year. Then it went up to $5,500, and now it’s up to $6,000 a year. This amount will continue to increase as the cost of living continues to increase (inflation).

Can contributions be taken out?

Contributions to a Roth IRA (not the earnings) can be taken out tax-free and penalty-free at anytime.

However, withdrawals on the earnings portion of your Roth, could cost you taxes and penalties. Here’s what to keep in mind.

If you take withdrawals from a Roth IRA before the age 59.5 and before the account is 5 years old, you may be able to avoid penalties (not taxes) if one of the following applies:

  • You withdrawal up to $10,000 for a first-time home purchase.
  • You withdrawal for qualified education expenses.
  • You withdrawal for qualified birth or adoption purposes.
  • You become disabled or pass away.
  • You withdrawal for medical expenses or health insurance if you’re unemployed.

If you take withdrawals from a Roth IRA before before the age 59.5 but after the account is 5 years old, your earnings will not be subject to taxes if you meet one of those conditions above.

If you’re over the age 59.5 and you take withdrawals, the following will apply:

  • If you haven’t met the 5 year requirement, your earnings will be subject to taxes but not penalties.
  • If you have met the 5 year requirement, your earnings will not be subject to taxes or penalties.

Are there required minimum distributions (RMDs)?

Unlike a Traditional IRA or company 401(k), a Roth IRA does not require minimum distributions (RMDs).

That means you can withdrawal whatever amount you want and keep the rest invested.

If you are averaging a 12% return and you live on 8% of the income each year at retirement, that keeps you even after inflation – which averages 4%.  That means you don’t even have to touch your nest-egg at retirement. You can potentially retire with x amount of dollars, live on 8% of that, and still pass on the full amount to someone else when you die.

Talk about a legacy!

By the way, if you have $5.8M at retirement, and only live on 8% of that, that’s $464,000 a year!  That’s a pretty nice income at retirement, I think.  Not to mention the fact, you’d still be able to give the $5.8M to someone else when you die.  That’s pretty crazy when you think about it.

Can you leave a Roth IRA to others?

One of the greatest things about a Roth is the tax-free savings, but it doesn’t stop there. You can also leave your Roth to others – a tax-free gift!

Related: What to Do With an Inherited Roth IRA?

One thing you wanna do is name a beneficiary as soon as possible. Whether it’s a child, family member, friend, or some other person/organization – you can designate a beneficiary and leave them your legacy.

What an amazing gift!

The Roth IRA has got some great benefits. If you are eligible, I would definitely take advantage of it.