A Roth IRA account is a very good way to increase your retirement savings. Knowing your Roth IRA basis of contributions is crucial to track your financial health. This is true even before you reach your retirement age.
You can only make good decisions in your retirement, even before that, if you have a complete overview of all your investments. Most people have a blend of different account types offered by financial institutions, and a Roth IRA may only be a part of that.
In this post, I’m looking at your Roth IRA basis of contributions and when you need to know about them.
What Are The Rules For Roth IRA Accounts
Understanding the basics and limitations of Roth IRA accounts is important.
Here are the simple IRS rules these accounts follow:
- Maximum income $153,000 (single), $228,000 (married, filing jointly)
- Your contributions are taxed when you make them.
- Qualified distributions are tax-free.
- Annual Contribution limit in 2023 of $6,500 ($7,500 if 50 or older)
- All contributions are nondeductible contributions
Can You Use A Backdoor Roth IRA Conversion?
If your income is higher than the limit for a Roth IRA, there is still the option to use a backdoor Roth conversion. With this strategy, you contribute your money to a traditional IRA account and roll it over to a Roth IRA account. As of 2023, this strategy is still allowed and is a great way to increase your retirement savings.
Remember to file IRS Form 8606 for every year you do such a conversion. With this form, you report to the Internal Revenue Service (IRS) that your initial traditional IRA after-tax contribution was not deductible. In other words, you aren’t taking a tax deduction from these after-tax dollars.
The Pro-Rata Rule applies since a backdoor Roth IRA conversion involves withdrawing traditional IRA funds. If your IRA contains both pre-tax and after-tax contributions, this rule determines the ratio that should be applied for the withdrawal. You can’t choose to only withdraw the after-tax portion when doing a withdrawal.
What Is Your Roth IRA Basis Of Contributions
In simple terms, it is the sum of all the money you have put in the account over its entire lifetime.
So, if you open a Roth IRA account and make a one-time payment of $6,000, that becomes your basis of contribution. Anything above that value is investment income.
Another example would be to make monthly payments of $500 instead. The result would be the same over a 12-month period.
Can You Withdraw From Your Roth IRA Without Penalty?
This is when knowing your Roth IRA basis of contributions is important. But you differentiate by age.
Withdrawals If You Are 59 1/2 And Younger
You can withdraw money from your Roth IRA account at any time. However, your withdrawal is only tax and penalty-free if you don’t take out more than your basis of contribution. Anything above that is subject to taxes and penalties.
If your Roth account is not older than 5 years (the five-year rule), the penalties can be avoided in some situations depending on the account age.
- Funds used for first-time home purchase ($10,000 max)
- Funds used for qualified educational purposes
- Funds used for qualified expenses related to birth or adoption
- Funds used for qualified medical expenses
- Account holder becomes disabled or passed away
If your Roth account is at least 5 years old, you can also avoid the taxes in the following circumstances:
- Funds used for first-time home purchase ($10,000 max)
- Account holder becomes disabled or passed away
Withdrawals If You Are Over 59 1/2
If you are over 59 1/2 years old, you will not pay any penalties for withdrawing money. But the tax situation is still to be taken into account.
If your account is under 5 years old, your earnings are still subject to taxes. No taxes and penalties are required if your account is older. This is when you can freely access your money and fully utilize your Roth IRA account and tax-free withdrawals.
Unlike a traditional IRA, a Roth IRA does not have required minimum distributions.
Looking At The Full Picture – Taxes On Retirement Income
When you reach your golden years and stop working, your entire income will have to come from your retirement savings and social security.
Knowing how your retirement income gets taxed will make a huge difference. It can help lower your taxable income and, thus, your entire tax bill.
You want to avoid taking out more than necessary. And you also want to avoid having to pay too much taxes.
For most retirees, the gross income they will need to replace is between 65% and 80% of their pre-retirement income. There are several reasons why it is below 100%:
- No need to save for retirement anymore
- Taxes decline without an active payroll
- Social Security benefits receive a favorable and lower tax rate
- Extra personal income tax exemptions over 65
- No work-related expenses
- Mortgages are eventually paid off
The different sources of your retirement income can be a combination of:
- Social Security
- 401k
- Traditional IRA
- Roth IRA
- Pensions
- And more…
The tax situation for all of these sources and retirement accounts is different.
Related Posts about employer-sponsored retirement plan:
Final Thoughts – Roth IRA Basis Of Contributions: How Does It Work?
Roth IRA accounts are a great way to improve your financial situation and get a tax break in retirement.
In this blog post, you have learned about the basic rules for Roth IRA accounts, including contribution limits, taxes, and penalties. You now know how and when your basis of contributions is essential and how you can calculate it.
Additionally, I looked at the full picture of your retirement and discussed how you can make your tax year successful by knowing your retirement income sources.
Every financial situation is different. You should consider working with a tax professional and financial advisor to make your retirement as successful as possible.
Finding a good financial advisor is not easy. I recommend the Garrett Planning Network, the National Association of Personal Financial Advisors (NAPFA), and the XY Planning Network. These networks can get you in contact with a fee-only advisor. No matter how much money we are talking about, it will not change your costs.
Disclaimer: The information in this blog post should not be considered tax advice or a replacement. They are solely provided for informational purposes. Please consult with a tax advisor for any specific questions on your taxes.
