Roth IRA Rules 2021

Your guide to deciphering Roth IRAs


Image of money being exchanged for a home.

This article is a condensed version of the different rules for Roth IRAs as specified by the IRS. If you’d like to skip directly to these rules, then you may by clicking one of the following:

If you are new to Roth IRAs, then please read the following quick overview of the differences between a Roth IRA and traditional IRA as well as a Roth IRA and Designated Roth Account first to verify that you’re looking at the right type of IRA.

Roth IRA vs Traditional IRA

Some differences between a Roth and traditional IRA are:

  • Contributions to a traditional IRA can be before-tax contributions while Roth IRA contributions are after tax.
  • A traditional IRA requires that you take distributions by the time your 72 while a Roth IRA does not require this for this for the original owner.
  • Both contributions and earnings distributed from a traditional IRA are taxable. Contributions and earnings distributed from a Roth IRA are not taxable as long as they’re qualified distribution (will be discussed in depth latter).

Roth IRA vs Designated Roth Account

Designated Roth accounts are distinct accounts that fall under a 401(k), 403(b), or 457(B) plan that allows elective deferrals that are called Roth contributions. Contributions to a Designated Roth are after tax. Qualified distributions from these accounts aren’t taxed. Some differences between the two types or IRAs include:

  • Different contribution limits.
  • A designated Roth may have a more restricted number of investment options.
  • A Roth IRA allows distributions at any time whereas a Designated Roth may have restrictions depending on the plan.
  • A Roth IRA does not allow loans whereas a Designated Roth does.
  • Different five-year holding period rules.

So, a designated Roth and Roth IRA may both have Roth in the name but are two separate things and shouldn’t be mixed up. Also, it’s important to note that the total contributions for one do not impact the total contributions to the other.

Rules for Roth IRA Contributions

Modified AGI for Roth IRAs

Before discussing the max total contribution amount, it’s important to understand what the modified adjusted gross income AGI for IRA purposes is. We’ll refer to adjusted gross income as AGI from here on for brevity.

To determine your modified AGI, take your AGI and:

  • Subtract Roth IRA conversions from form 1040, 1040-SR, or 1040-NR on line 4b.
  • Subtract Roth IRA rollovers from qualified retirement plans included on form 1040, 1040-SR, or 1040-NR on line 5b.
  • Add the IRA deduction from form 1040 line 19.
  • Add tuition and fees deductible from form 1040 line 21.
  • Add exclusion of interest from Form 8815, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989.
  • Add exclusion for employer provided adoption benefits from form 8839, Qualified Adoption Expenses.
  • Add foreign earned income exclusions from form 2555, Foreign Earned Income.
  • Add foreign housing exclusion or deduction from form 2555.

If none of the conditions above apply, then your modified AGI will simply be your AGI.

Roth IRA Contribution Limit

The max total contributions amount you can make in 2021 is $6,000 if under 50 and $7,000 if 50 or over. But, there are some additional rules around this.

If you are married filing jointly or a qualifying widow(er), then the following rules apply based on your modified AGI:

  • Your modified AGI is less than $198,000, then up to the max contribution amount previously mentioned.
  • If over $198,000 but less than $208,000, then a reduced amount, which will be explained at the end of this section.
  • If greater than or equal to $208,000, then you can’t contribute.

If married filing separately and you lived with your spouse at any point during the year, then the following rules apply based on your modified AGI:

  • Your modified AGI is less than $10,000, then a reduced amount, which will be explained at the end of this section.
  • Your modified AGI is greater than or equal to $10,000, then you can’t contribute.

If single, head of household, or married filing separately and you did not live with your spouse at any point during the year, then the following rules apply based on your AGI:

  • Your modified AGI is less than $125,000, then up to the limit.
  • Your modified AGI is greater than or equal to $125,000 but less than $140,000, then a reduced amount, which will be explained at the end of this section.
  • Your modified AGI is greater than or equal to $140,000, then you can’t contribute.

To calculate the reduced contribution amount, you can do the following:

  1. Take your modified AGI, subtract one of the following:
    • $198,000 if filing a joint return or a qualifying widow(er).
    • $0 if married filing separately and you lived with your spouse at any point during the year.
    • Otherwise, $125,000.
  2. Divide the above results by:
    • $10,000 if filing jointly, are a qualified widow(er), or married filing a separate return and you lived with your spouse at any point during the year.
    • Otherwise, divide the result by $15,000.
  3. Multiply this by the maximum contribution limit.
  4. Subtract the previous results from the maximum contribution limit.

For example, say that an individual who is 40 has a modified AGI is $130,000. The reduced contribution amount would be $4,000, which is calculated as follows:

  1. $130,000 - $125,000 = $5,000
  2. $5,000 / $15,000 = 0.333
  3. 0.333 * $6,000 = $2,000
  4. $6,000 - $2,000 = $4,000

Excess Contributions

If your total contributions exceed those discussed under the “Max Total Contributions Amount” section, then the IRS will impose a 6% tax on the excess contribution every year until you no longer have excess contributions.

If you find that you did contribute too much, you can fix this by removing the excess contributions and any earnings on those contributions by your tax return’s due date. The IRS will treat this as if you never made the contribution. Just make sure to include any earnings on the withdrawn amount as standard income for that year for tax purposes.

Or, you can apply the excess amount to the next year’s contribution if it is less than the next year’s max total contribution amount. Though, note that if you don’t withdraw the excess contribution first, then you’ll still need to pay the 6% excise tax on the original year where the max contribution was exceeded. Doing this only removes the need to pay the 6% excise tax on subsequent years.

Rules for Roth IRA Withdrawals

Before discussing this section, it’s important to understand what is meant by “basis” in the context of an IRA. An IRA basis is the portion of the IRA where taxes have already been paid.

Also, we’ll be using the more formal term of distribution rather than withdrawal from here.

Distributing Original Contributions

You can take out money you’ve added to the Roth IRA via regular post-tax contributions at any time without tax penalties as you’ve already paid taxes on this amount (this is your basis). Earnings/profits are different though. For earnings/profits, you’ll need to make a qualified distribution or make another distribution not subject to the 10% additional tax in order to avoid paying this additional tax. Both of these are discussed next.

Qualified Distributions

Qualified distributions are distributions where it’s been at least five years after the first tax year a contribution was made and one of the following conditions is met:

  • You’re at least 59 ½.
  • You’re disabled.
  • You meet the first-home requirements (up to $10,000 lifetime max per individual to buy, build, or rebuild your first home).
  • You are a beneficiary of an IRA owner that has passed away.

With a qualified distribution, no part of the distribution will be taxed including earnings. This is the main benefit of a Roth IRA and what really sets it apart.

Early Distributions Not Subject to the 10% Additional Tax

Early distributions that don’t require the 10% additional tax:

  • All of the listed items under "Qualified Distributions" with the exception that the five-year period has not yet elapsed.
  • You have unreimbursed medical expenses that are greater than 7.5% of your AGI for the year.
  • Your qualified higher education expenses are greater than the distributions.
  • The IRS levies the plan leading to a distribution.
  • It is a qualified reservist distribution.
  • The distributions are part of a series of substantially equal payments.
  • You are paying medical insurance premiums during a period of unemployment.

While the 10% additional tax may not apply, you will still be required to include any earnings as income for the year with this type of distribution.

Non-Qualified Distributions Where 10% Additional Tax Applies

If you make a non-qualified distribution that also isn’t included as one of the early distributions that is exempt from the additional 10% tax, then a portion of that distribution may be taxed.

To determine how much of the of the distribution will be taxed:

  1. Take the amount of the distribution that isn’t qualified and isn’t exempt from the 10% tax for one of the reason as described under the (Early Distributions Not Subject to the 10% Additional Tax) section.
  2. Using this amount, take the basis amount in the existing Roth IRA (amount where taxes have already been paid, which will generally be everything except earnings on the contributions).
  3. Subtract this amount from the distribution. If greater than 0, then you’ll need to pay a 10% tax on this amount.

As a simplified example, say that a $100,000 non-qualified distribution is being made from a Roth IRA where the distribution isn’t an exemption from 10% tax rule. The existing Roth IRA has a total amount of $100,000 with a basis of $80,000. This means that $20,000 will be subject to the 10% rule, which is $2,000. This is in addition to your normal income taxes on this amount.

For more information from the IRS, see part III of the following on form 8606 where this is calculated at the following: IRS Form 8606

Distributions After Owner’s Death

A Roth IRA does not require minimum distributions for the original owner. If the owner passes away though, then the minimum distribution rules fall back to those of a traditional IRA as if the owner passed away the direct period before the require minimum distribution starting date. Note that as a beneficiary, you want to pay special attention to this rule, if applicable, as a failure to take the required minimum distribution may lead to a 50% excise tax on the amount not distributed.

Usually, the entire Roth IRA amount must be distributed by the end of the fifth (applicable individual designated beneficiary) or tenth (no individual designated beneficiary) calendar year after the owner’s death unless the distribution it is paid using the life expectancy rules of the given beneficiary (certain rules are required to use this option).

One exception to the above is if the only beneficiary is the spouse. In this case, the spouse can decide to take distributions starting on the year the original owner would have reached 72 or treat the Roth IRA as their own. If the spouse does treat the Roth IRA as their own, then he or she has the option to combine it with one of their other Roth IRAs.

The same rules around qualified distributions apply to distributions made after the owner’s death as well. As mentioned in the “Early Distributions Not Subject to the 10% Additional Tax” section, the 10% additional tax rule does not apply to distributions made after an owner’s death. Though, if the distribution isn’t qualified, then the earnings portion of the distribution is subject to standard income taxes.

Rules for Rollovers into a Roth IRA

Before discussing how to rollover to a Roth IRA, it’s important to understand what a trustee is. In the financial world, you can enter into an agreement called a trust wherein financial assets (real estate or financial accounts) are managed according to conditions outlined in the trust that you the grantor agree to.

The entity with rights to manage the assets in the account is called the trustee. The trustee is usually the only one with authority to access the funds in the trust, handle distributions, and conduct other business on behalf of the trust. The trustee also has a duty to the current and potentially future beneficiaries to handle the trust responsibly and in the best interest of the applicable beneficiaries.

In the context of retirement accounts like a 401(K) or traditional IRA, the trustee is the entity who manages the accounts according to the rules set out by the trust.

That said, there are three main ways to transfer from a given retirement account or traditional IRA into a Roth IRA:

  1. Same Trustee Transfer
    If the same trustee holds both the account you’re transferring from and the Roth IRA account you’re transferring to, then you can ask the trustee to do the transfer for you. For example, if the funds you want to transfer and the Roth IRA account you’re transferring them to are both managed by the same investment company, then you should be able to make a request to that company to perform the transfer. The funds will never be in your hands directly (e.g., via a check), which simplifies the process and taxes at the end of the year.

  2. Different Trustees Transfer
    If the Roth IRA is to be opened under a different trust and corresponding trustee, then you can direct the trustee of the funds to transfer those funds to the other trustee. As with a same trust transfer, the funds don't go through you simplifying the process and end of year taxes.

  3. Rollover Where the Funds Go through You
    Unlike the previous two methods, in this method the funds go through you (usually via a check). If you can use one of the previous two methods, then it is recommended to do so to to avoid any complications at the end of the year with tax preparation. But, if you do decide to use this method, be sure to ask that the check is written out to the new Roth IRA account rather than yourself. If the check is written out to yourself, then you have 60 days to transfer those funds to the Roth IRA. Otherwise, an additional tax penalty of 10% may be applied on some or all of the transferred funds depending on the account type that is being transferred from.

If transferring from a retirement account or traditional IRA, the funds to be transferred will likely be pretax. Since Roth IRAs only accept post tax contributions, the transferred funds from the retirement account or traditional IRA will need to be included as income in your taxes for the year. Also, you may be subject to an additional 10% tax on the full amount of the conversion if not doing a directe trustee to trustee transfer as previously described.

If transferring from a Designated Roth, then the source funds are post tax meaning that there will be no additional tax burden on the distributed funds as long as you do a direct trustee to trustee transfer. Otherwise, you may need to pay a 10% tax on part the distribution (earnings).

Sources

  1. IRS - 8606 Instructions
  2. IRS - Roth Contributions for 2021
  3. IRS - Publication 590-B
  4. IRS - Rollovers Faq

Disclaimer

While all efforts have been made to ensure the accuracy of the information presented, please note that there is still the possibility for inaccuracies or omissions. This article is not meant as an absolute source to all potential scenarios or authority for Roth IRAs and shouldn’t be used solely for your Roth IRA decisions. If you are unsure or have any additional questions on the rules for Roth IRAs, then please review the IRS documents directly and/or consult with a qualified professional.