Are Roth IRA contributions tax deductible?
The simple answer is no. However, a closer look at the details reveals a more nuanced answer.
Although Roth IRA contributions themselves are not tax deductible, you can claim a Roth IRA tax credit or a claim a loss on a Roth IRA if you are eligible and meet certain requirements.
If you're wondering how exactly that works, here are some details and scenarios to consider.
Non-Deductible Roth IRA Contributions
Unlike 401(k) or Traditional IRA contributions, Roth IRA contributions are not tax deductible. According to the Roth IRA funding rules established by the IRS, all your contributions must be made with after-tax dollars.
For example, let's say you earn $40,000, and you're in the 25% tax bracket. If you want to make a $5,500 tax deductible 401k contribution, you'll put $5,500 in your 401(k) first and then you pay your taxes, which leaves you with $25,875 (75% of $34,500).
However, if you make a $5,500 non-deductible Roth IRA contribution, you'll pay your taxes first, which leaves you with $30,000 (75% of $40,000). By making that $5,500 Roth IRA contribution with after-tax dollars, you'll be left with $24,500 in disposable income. While stashing that money away in your Roth IRA is certainly a smart move, it will leave you with less money to spend throughout the year.
Still, the complexity of the situation doesn't end there. Just because your Roth IRA contributions aren't tax deductible doesn't mean you can't take advantage of certain provisions which provide a benefit similar to a deduction.
Yes, you read that right. Despite what you may have heard, you can potentially get a tax benefit by using a Roth IRA. How is this possible? Keep reading to hear more.
My favorite online broker is Trade King but you can check out our recap on the best places to open a Roth IRA and the best online stock broker sign up bonuses. There are many good options out there, but I have had the best overall experience with Trade King. No matter which option you choose the most imporatant thing with any investing is to get started
The Roth IRA Saver's Tax Credit
While your Roth IRA contributions are not tax deductible, you can claim a Roth IRA tax credit on IRS Form 8880 of up to 50% on your first $2,000 in Roth IRA contributions if your income falls within the predetermined income limits. This tax credit is called the Saver's Tax Credit. Here's how the numbers and income limits worked out for 2016:
You can receive a 50% tax credit on your first $2,000 in Roth IRA contributions if you're:
- Single and earn $18,250 or less
- Married filing jointly and earn $36,500 or less
- Head of Household and earn $27,375 or less
You can receive a 20% tax credit on your first $2,000 in Roth IRA contributions if you're:
- Single and earn between $18,251 and $19,750
- Married filing jointly and earn between $36,501 and $39,500
- Head of Household and earn between $27,376 and $29,625
You can receive a 10% tax credit on your first $2,000 in Roth IRA contributions if you're:
- Single and earn between $19,751 and $30,500
- Married filing jointly and earn between $39,501 and $61,000
- Head of Household and earn between $29,626 and $45,750
Where to Open a Roth IRA
Opening a Roth IRA is always a good idea, but if you fall into one of the above income categories then going without a Roth IRA could cost you a huge break on your taxes. The beautiful thing about tax credits is they are a direct reduction in the amount of tax you owe, whereas tax deductions only lower your taxable income.
If you can benefit from funding a Roth IRA and getting a Saver's Tax Credit, there are plenty of websites that make opening this type of account simple and painless. Here are a few of my favorite options:
Scottrade is a great place to open a Roth IRA. Once you sign up, you'll get inexpensive trades, fantastic customer service, an easy to use online interface, and the ability to talk with someone in person. Scottrade also has over 500 physical branch locations around the country so if you ever get stuck you can drive in to the closest branch to get help. If you're like me and want the option to talk to a real, live human being, this brokerage firm might be exactly what you need.
Open a Roth IRA account with Scottrade and get your Saver's Tax Credit this year.
If you don't want to have to pick specific investments then Betterment is a great choice to open a Roth IRA with. The company makes investing incredibly simple: you just select how much risk you can handle on a sliding scale, and the actual investment mix is taken care of by the company.
The risk-averse investor gets a basket of pre-selected lower risk bond ETFs and the investor wanting higher returns gets a basket of pre-selected stock ETFs. (If you select a 60% stock and 40% bond mix, the investments adjust automatically for you.)
Open a Roth IRA account with Betterment and get your Saver's Tax Credit this year.
If you are just starting out investing there is one broker that was built for you: TD Ameritrade.
ShareBuilder is all about setting up good investing habits. Instead of offering overwhelming trade charts and confusing interfaces, the company focuses on helping you automatically invest your funds each month at rock bottom prices. If you invest automatically trades can be as low as $4 per month. Compared to other online brokerage firms, this is an exceptionally good deal!
Open a Roth IRA account with TD Ameritrade and get your Saver's Tax Credit this year.
Two Good Financial Cents Resources for Opening a Roth IRA
Still not sure where to open an account? Don't worry, we've created a set of resources that can help you make a thoughtful and research decision. Before you choose one broker over another, consider the information offered in these resources:
More from GFC, Below
- Best Places to Open a Roth IRA: This is a breakdown of some of the best brokers to open up a Roth IRA with. You'll find out about the benefits of each broker as well as some of the costs in terms of trades, account maintenance, and the minimum deposit needed to open an account.
- Best Online Stock Broker Sign Up Bonuses: Online stock brokers are willing to give you cold hard cash or pricey electronics to sway your decision when opening up an account. This is a list of all the current sign up offers. You might be surprised at how much you can get for your account.
Claiming Roth IRA Losses
Beyond the Saver's Credit, there are additional tax considerations to take note of when it comes to investing in a Roth IRA. While your Roth IRA contributions are not tax deductible, you can claim Roth IRA losses under certain circumstances. Just remember that only a loss of your original Roth IRA contributions constitutes a loss, not simply a declining balance.
For instance, if you've contributed $25,000 to your Roth IRA over the years, but your account is now worth only $20,000, then you've experienced a $5,000 loss. But if you've contributed $25,000 over the years, and your Roth IRA balance declines to $50,000 from $60,000 one year ago, this is not considered a loss. It's considered a $25,000 gain.
Assuming you've experienced a real loss in your Roth IRA, you are able to claim that loss on your tax return, but only if all of the following apply:
- You close all of your Roth IRA accounts
- You claim your loss on an itemized tax return
- The loss exceeds 2% of your Adjustable Gross Income (AGI), and
- You're not subject to the Alternative Minimum Tax (AMT)
Assuming your situation meets each of the above factors, you're eligible to claim a loss on your tax return, but only the amount above 2% of your Adjustable Gross Income (AGI) is tax deductible. Let's take a more in-depth look at each factor:
- You Close All Roth IRA Accounts – To claim a loss, you must close every Roth IRA account in your name, withdrawing every dollar. For instance, let's say you have one Roth IRA account with E*TRADE and another with Scottrade. If you've experience a loss in one account, you can't just close that account and claim the loss. You must close both accounts.
- You File An Itemized Return – In order to claim a Roth IRA loss, you must file an itemized tax return and claim the loss on Schedule A – Itemized Deductions (Form 1040). Do not claim the loss on Schedule D – Capital Gains and Losses. This is a common mistake, because it just seems like the proper place to report a loss on your investments, but it's not. On Schedule A, your loss goes in the category “Miscellaneous Deduction”.
- Your Loss Exceeds 2% Of Your AGI – It's not enough to simply lose money, your loss must exceed 2% of your Adjustable Gross Income (AGI) in order for you to claim it. For instance, if you have a $500 loss, but $50,000 in AGI, you can NOT claim a loss. Why? Because $500 is only 1% of your AGI, but a $1,500 loss can be claimed because it's 3% of your AGI.
- You're Not Subject To The AMT – If you're subject to the Alternative Minimum Tax (AMT), you can't claim a loss. Why? Because in order to claim a loss, you must do so as a “Miscellaneous Deduction” on Schedule A (Form 1040), and Schedule A Miscellaneous Deductions are NOT deductible if you're subject to the AMT.
Once you're satisfied that you meet the requirements necessary to claim a Roth IRA loss on your tax return, you're free to deduct any amount above 2% of your Adjustable Gross Income (AGI). For instance, suppose you have a $100,000 AGI, and you claim a $4,500 Roth IRA loss. How much are you able to deduct? $2,500. Why? Because only the amount above 2% is deductible, so you're not able to claim the first $2,000 of your loss, only the remaining $2,500.
Why Should I Open a Roth IRA?
Now that we've covered the different ways you might score a tax break by contributing to a Roth IRA, let's highlight the many instances in which opening this type of account makes sense. Let's start at the beginning.
A Roth IRA offers one more way to save for retirement.
If you're trying to build a hefty nest egg for retirement, a Roth IRA offers yet another option to do so. The best part is, you can contribute to a Roth IRA (or traditional IRA) even after you max out your company-sponsored retirement or 401(k) plan. For 2016, the contribution limits for both your Roth IRA and traditional IRAs combined is $5,500, although individuals age 50 and over can contribute up to $6,500 as a “catch up contribution.”
Roth IRAs allow you to diversify your exposure to taxes.
When you contribute to a 401(k) or other tax-advantaged account, you save money on taxes now with the promise to pay them when you begin taking withdrawals. A Roth IRA, on the other hand, requires the opposite approach. By investing in a Roth IRA with after-tax dollars, you can look forward to tax-free withdrawals when you reach retirement age. If you believe you might be in a higher tax bracket upon retirement, investing in a Roth IRA is also one way to shield yourself from higher taxes in the future.
You can withdraw your contributions at any time with no penalty.
Unlike other retirement plans, the Roth IRA offers some pretty generous rules when it comes with removing your funds from an account. As of today's writing, you can withdraw any contributions from your Roth IRA at any time without penalty. You'll notice I said contributions, and not earnings, however. Let's say you contributed $5,500 to your Roth IRA the last few years for a total contribution of $11,000, but managed to accumulate $1,000 in earnings during that time. Per Roth IRA rules, you are only able to take out your initial contributions without penalty, which includes the original $11,000 you put in.
You won't be forced to take distributions once you reach a certain age.
One reason so many people love the Roth IRA is because it offers utmost flexibility in retirement. Not only can you take out your contributions early if you need to, but you aren't forced to take distributions once you reach a certain age, either. Where a 401(k) and traditional IRA force you to begin taking distributions at age 70 1/2 or pay a penalty, the Roth IRA lets you take out your funds whenever you want. If you want as many financial options as possible when it comes to riding out your retirement, this is a huge benefit.
You may not be able to contribute in the future if your income grows.
If you think you might earn more money in the future, contributing to a Roth IRA now is a very smart move. Even though a high income might preclude you from using this investment vehicle in the future, any funds you stash away in a Roth IRA will continue growing until you need them.
How to Qualify For a Roth IRA
You might be wondering what it takes to qualify for a Roth IRA to begin with. Since there is a different set of eligibility requirements for each type of retirement account, it's easy to become confused. Here are the main factors to consider when figuring out whether or not you can contribute to a Roth IRA this year:
You must have earned income during the year you want to contribute. To become eligible to contribute to a Roth IRA, you must have earned income during the year you hope to contribute. This income can come from a full-time or part-time job, self-employment, or a small business. The limits you can contribute, however, depend on your age. If you're under the age of 50, you can contribute a maximum of $5,500 combined to a Roth IRA or traditional IRA account. If you're over age 50, on the other hand, the maximum you can contribute is $6,500.
Your income must fall within or beneath certain guidelines. Due to the way the Roth IRA was set up, you must meet certain income guidelines to contribute each year. Also keep in mind that, if your income fluctuates, you may be able to contribute to a Roth IRA in certain years and not others. It all depends on how much you earn in any given year, and how close you are to exceeding the Roth IRA income eligibility caps.
For 2016, married couples filing a joint return must earn less than $184,000 to make the maximum contribution. Between $184,000 and $194,000, the maximum contribution begins phasing out. For single filers, heads of household, or married filing separately without living with their spouse that year, the phase-out range starts at $117,000 and ends at $132,000. Anyone who falls into that category and earns less than $117,000 can contribute the maximum contribution this year.
Do you have a Roth IRA? Why or why not?