Key Elements of the U.S. Tax System

A Roth IRA is a form of individual retirement account in which investors make contributions with after-tax earnings. Eligibility is limited by income. There’s still a big tax break: contributions accrue tax-free in the account, and withdrawals are not taxed under normal circumstances. In tax year 2017, nearly 21 million taxpayers, or 10 percent of all taxpayers, owned a Roth IRA.

ELIGIBILITY AND CONTRIBUTION LIMITS

Only people with incomes under specified limits are eligible to contribute to a Roth IRA. In 2020, the contribution limit for IRAs is the lesser of $6,000 ($7,000 for individuals over age 50) or the taxpayer’s taxable compensation. The contribution limit falls once household income exceeds certain thresholds, eventually reaching zero (table 1).

WITHDRAWALS

Investors can withdraw their contributions (but not investment returns earned on those contributions) at any time without being subject to tax. However, to receive tax benefits on investment returns, withdrawals must be qualified distributions. This means that the investor withdraws funds at least five years after his or her first contribution and after reaching age 59 years and 6 months, dying, becoming disabled, or making a qualified first-time home purchase. Nonqualified distributions do not satisfy the above conditions, and the investment earnings portion of the distributions is subject to tax and possibly a 10-percent penalty tax. There are several exceptions to the penalty for early withdrawal of investment earnings.