Roth IRA Explained

Named after Senator Roth of Delaware, the Roth IRA is a tax-free retirement investment account everyone should consider if they are eligible. While the contributions to a Roth IRA are not tax deductible (a negative), the gains will not be taxed on distribution when you retire (a positive). This allows the investor to diversify his or her tax exposure because most retirement accounts (most IRAs, 401k’s, 403b’s) work the other way, contributions are tax deductible but the distributions are taxed in retirement. If you believe your tax rate will be higher when you retire, the Roth IRA is for you; if you believe it will be lower, the other options are for you. Since you likely don’t know, given the uncertain nature of the tax environment, using both allows you to hedge your bets.

Your contribution is limited to $4,000 in 2007, $5,000 in 2008 (+$500 increments thereafter based on inflation) or the amount of income you earned that year. Those 50 and over can contribute an additional $1000. If you earn over the income phaseouts, which in 2007 start at $95k for single filers, then your contribution is also limited based on the phaseout rules.

There you go, a two minute primer on Roth IRAs!

One of the biggest decisions you can make with your Roth IRA, besides what you will be investing in, is which broker you’ll be investing through. While it may appear that all brokers are fairly equal, the reality is that they can be very different and it’s very important that you figure out what you need in a broker and pick one that can fulfill those needs.

When I thought about my Roth IRA, I knew that I wanted to be investing individual stocks. So I compared stock brokers that excelled in superior customer service, low commission rates, and had reasonable, hopefully low, fees. Since I didn’t have a lot money to invest, I chose one that didn’t have an account minimum and didn’t have inactivity fees (buy and hold!). Incidentally, I went with TradeKing and you can read a review of their service on this TradeKing review post.

On the flip side, the other choice is if you wanted to invest in mutual funds, like index funds. If you want that, I recommend going directly to the mutual fund company itself. If it’s a Vanguard index fund, go to Vanguard. If it’s Fidelity, go to Fidelity. Usually you won’t have to pay a fee to buy or sell shares of a mutual fund if you work directly with the mutual fund. Otherwise, fees are usually $40-50 a trade!

Hopefully that will help you decide which broker to use for your Roth IRA!

While most of the posts on this site discuss small parts of the Roth IRA in detailed, another site has tackled the whole concept and laid it out on in a single article. If you want a good overview, with significant detail, on a Roth IRA account then head over to Bargaineering.com. It’s a little light on the finer tax details but otherwise a good explanation of the Roth IRA from a high level.

TradeKing is one of the first brokers to offer a cash promotion for a transfer and it’s sizable, $150!

TradeKing was named the #1 Discount Broker by SmartMoney in 2006 and 2007, before they changed their ranking system and removed the “discount” category. They were also recently awarded the highest ranking of four stars by Barrons in their annual survey of the Best Browser-Based Online Brokers. Stock trades cost only $4.95, including broker assisted trades, and they’ve consistently been named one of the best for customer service every year.

Moving Roth IRA plan assets from one Roth IRA to another Roth IRA is very easy, it’s known as a transfer and it is a tax-free, non-reportable movement of assets between retirement plans. Moving assets from one Roth IRA to another can be accomplished through a transfer and there is no limit on the number of transfers you can have between the trustees or custodians.

Call up the destination trustee/custodian and ask them to explain their Roth IRA transfer process. It should be pretty straightforward, they want your business! They’ll probably have you open the Roth IRA account. They may have forms you need to fill out or an account number you need to put on the check (or in a letter accompanying the check to give them instructions).

You’ll also want to find out the name you need to put on the check. For Vanguard, the name is Vanguard FTC and not just Vanguard Group because the name for the check is Vanguard Fiduciary Trust Corporation. You’ll need to call to get the name of your trustee/custodian, don’t guess.

Next, call up the original trustee/custodian and request a transfer, give them the name of the destination trustee/custodian. Some trustees will mail the check to you, some will mail it directly to the destination, it’s up to them. Some trustees will also charge a fee to close, if you can, try to pay for it separately and not have it deducted from your account (you want your retirement funds to be as large as possible so it can grow tax-free).

Once you receive the check, forward it along to the next trustee along with a letter of instruction and you should be all set.

Can you invest your Roth IRA in something safe, like a certificate of deposit?

Yes you can, but it’s a little tricky because you can’t buy certificates of deposit (CD) through a typical Roth IRA brokerage account. What you’ll need to do it open an IRS CD with the institution you want the CD from. So, the first step is to review the best certificate of deposit rates and look at their IRA CD offerings. The highest regular CD rate won’t necessarily guarantee a high IRA CD. The banks know that you get favorable tax status so the rates may be lower.

A certificate of deposit is a type of deposit account where you are guaranteed a rate of return over a specified period of time, known as the term. It differs from other accounts because the rate is guaranteed, whereas for many types of accounts the rate is not guaranteed. In return for this guarantee, your money is locked into that account until the maturity of the CD. If you need your funds before the CD matures, you will often have to pay a penalty. One of the benefits of having your IRA in CDs is that you probably won’t try to access the funds early because you would have to pay an early withdrawal penalty on the IRA as well.

Check to see what the rules are with the IRA CD at the bank you’ve selected, they should be able to explain how everything works.

Roth IRA is a great vehicle if you’re eligible. Unfortunately, there are certain income restrictions that may prevent you from participating. There is both a lower limit and a higher “range” that may exclude you from participating in this tax-free investment vehicle popularized in the last decade.

Lower Income Limit

The lower income limit refers to how you must earn income in order to contribute it to a Roth IRA. The 2008 annual contribution limit for Roth IRAs is $5,000, with a $1,000 catch-up contribution for those aged 50 and above. Every dollar you contribute must have been earned in that year, so if your tax return filing says you earned $500 (after taxes) this year then you may only contribute $500 this year.

The $500 you contribute does not necessarily have to be the $500 you earned. One example is for children. If they earned $500 but spent it on candy, parents can elect to give them $500 to contribute.

Upper Income Range

There is a phase-out range for the upper limit, where the $5,000 contribution limit is slowly phased out in $20 increments. The phase for Single tax filers begins at $101,000 and ends at $116,000. If you earn less than $101,000 then you can contribute the full $5,000. If you earned more than $116,000 then you can’t contribute anything. Within that $101k to $116k, simply figure out how far into the range you are and apply that percentage to the contribution limit – rounding up to the nearest $20. The limits are different for other filing statuses (Traditional and Roth IRA Contribution Limits).

With all the chaos in the financial markets, you’re probably a little concerned as to what will happen to your Roth IRA or Traditional IRA in the event your bank goes under. Fortunately, you don’t have to be as long as you have less than $250,000 in your account at a particular bank. Effective April 1st, 2006, the coverage limits for retirement accounts, which include traditional and Roth IRAs, was increased from $100,000 (the same as deposit accounts) to the current level of $250,000.

The other retirement accounts included are self-directed Keogh accounts, 457 Plans for state governemnt employees, and employer-sponsored “defined contribution plans” like 401(k)s.

Remember, this is protection again bank failure and does not cover the value of your assets. For example, if you bought a particular stock and it loses value, FDIC does not protect you against that (that would be completely unreasonable). However, if your bank does go under and it was the administrator of a 401(k) plan, you’d be protected up to $250,000.

One of the most popular questions I get is whether a teenager can get a Roth IRA and the answer is yes, as long as they have income.

The rule for the Roth IRA is that you can contribute based on how much you’ve earned in a year. If you’ve earned $2,000, you can contribute up to $2000 (after taxes) to your Roth IRA. If you earned more than $5,000 then the limit for the Roth is $5000.

When it comes to teenagers, you will want to open a custodial account at a brokerage. Since they’re under the age of 18, they can’t open their own account but you can open one on their behalf, you are their custodian, which is effectively the same thing. For all intents and purposes, the account is theirs but you are watching over them to make sure they don’t make any mistakes, right?

Remember, they can only contribute as much as they declare on their taxes. So, if they’ve been mowing lawns and don’t intend to claim that income on a Form 1040, they can’t put that towards their Roth IRA. Technically, your children have to claim that income but if they don’t, they can’t use it towards their Roth IRA.

I met with my accountant this week and one of the things we discussed was retirement. I told him that I was going to try to take advantage of the 2010 Roth IRA conversion loophole by contributing to a non-deductible Traditional IRA starting this year (2008). A quick recap on the rule is that right now you have to earn under a certain amount to be eligible to convert, in 2010 that rule disappears and anyone can do the conversion. With respect to taxes, you pay income tax on the amount you convert and that amount now enters the Roth IRA world.

So, the recommendation he gave me was that if I’m going to do this, I need to keep my non-deductible Traditional IRAs segregated from my other Traditional IRAs. Right now I have a Rollover IRA at Vanguard so I will want to keep that one separate from the non-deductible one. When it comes to do the conversion, I won’t have any headaches separating the two. When I do the conversion, I pay no tax because I never deducted the contribution in the first place.

What happens if I don’t separate them? You have some minor headaches. The conversion process allows you to pick how much you want to convert. You can convert the whole thing or convert a part. When you mix the deductible and the non-deductible, you make things a little more chaotic. If you opt to convert only 50%, you can’t convert just the non-deductible part, you’ll have to convert based on the weightings. This is better explained with an example.

Let’s say your IRA has $8,000 in deductible IRA contributions and $2,000 of non-deductible IRA contributions. If you elect to convert 50% of that IRA to a Roth IRA, you’ll have to take $4,000 of the deductible contribution and $1,000 of the non-deductible. You can’t choose to take $2,000 of the non-deductible and $3,000 of the deductible IRA. If you keep them in separate accounts, you can convert them independently and thus avoid this problem.

If you’re thinking about converting your Traditional IRAs into Roth IRAs, paying the taxes, and then watching your earnings grow tax free, great! If you’re also taking Social Security benefits, you might want to take a step back and talk to a professional tax accountant before you do that conversion.

When you convert a Traditional IRA into a Roth IRA, you declare that converted value as income. As you probably now know, that income can affect your Social Security benefit payout for the year. If your total worldwide income, including tax-exempt income and half of Social Security, exceeds a certain amount, then your Social Security benefit may be subject to taxes.

For Single filers and Head of Household, the first level is at $25k. For Married Filing Jointly, the first level is at $32k. If your total income, including tax-exempt and half of SS, then 0% of your benefit is taxed. If, as a Single or HoH, you earn between $25k and $34k ($32k and $44k for MFJ), then you will pay taxes on 85% of your SS benefit. If you earn more than $34k (or $44k), then 85% of your SS benefit is taxable.

It’s something to factor in if you are considering converting your IRAs.

Consider a Roth IRA as a graduation gift this summer.

Yep, that’s right, a Roth IRA. Most college graduates probably aren’t thinking about retirement right now, in fact they’re just looking forward a relaxing summer followed by their first paycheck. However, as a responsible adult (ha!) you may consider giving that graduate a Roth IRA and get them started on saving for their future.

Earned Income. The rule with contributions is that a person has to earn as much “earned income” in order to contribute that to their Roth IRA. The dollar they earn doesn’t necessarily have to be the dollar they contribute so as long as your graduate will be earning money, you can probably open a Roth IRA on their behalf. If the graduate has a job, chances are he or she will have sufficient earned income to cover your Roth IRA contribution (the $5,000 contribution limit for this year).

Another side benefit of this gift is that it helps the graduate recognize the importance of retirement and lets them know about the Roth IRA, if they don’t know about it already.

It was announced today that the Pentagon supports proposed changes to the Thrift Savings Plan that would automatically sign up troops for the TSP as well as offer the Roth IRA as an investment option. The first proposed change, automatic sign-up, was recently instituted in the private sector and has resulted in increases in employee participation. It’s thought that automatic sign ups for TSPs would increase participation as the main reason people don’t sign up is due to inertia, it takes effort to.

The second proposed change involves introducing Roth IRA as an option in the TSP which would result in significant savings for deployed troops since they do not pay taxes on their earnings or bonuses while they are in war zones. With a Roth IRA, you contribute after-tax dollars and appreciation is tax free. Troops in a combat zone are in the 0% tax bracket, so they benefit tremendously from the Roth IRA option.

Those troops who are not in combat zones also benefit from the Roth IRA option because it gives them tax diversification.

DoD backs automatic TSP enrollments [Air Force Times]

How much you can contribute to a Roth IRA depends on your income and the contribution limits of the year. For 2008, the contribution limits for a Roth IRA is $5,000. Follow these rules to determine your maximum Roth IRA contribution.

• If your adjusted gross income is under $5,000, you can only contribute your AGI,
• If your AGI is greater than $5,000 but less than $101,000 (single filers) or $159,000 (for married filing jointly filers), then your maximum contribution is $5,000.
• If your AGI is between $101,000-$116,000 (single filers) or $159,000-$169,000 (for married filing jointly filers), then you can contribute a fraction based on where your income is with a few special rules:

If your AGI as a single filer was $110,000, then your fraction is (1 – ($110,000 – $101,000) / $15,000 (the range)) = (1 – 0.6) = 0.4. Then take 0.4 x $5,000 = $2,000. Your contribution limit is $2,000. (sorry! my original equation was messed up!)

Special Rules:

Also, the minimum maximum contribution amount is $200. So, if your AGI is within 4% of the maximum, then you get credit for the 4% ($200).

The Roth IRA 120 day rule refers to the amount of time you have between withdrawing funds from your Roth IRA and when you must use them to pay for ‘qualified acquisition costs’ (closing costs) related to your first home. If you are running close to the 120 day limit, simply contribute the funds back into the IRA (or roll it over to a new IRA) and then withdraw them later. If you fail to use the funds within 120 days, it’s considered a disbursement and you may be subject to penalties.

Incidentally, if you do run into a snag and end up rolling it over to another account, the typical 60 rule no longer applies and this is considered a special rollover. You also don’t have to worry about the rule regarding only one rollover within a 12 month period, it won’t apply for this special case.

If you’ve been reading a lot about Roth IRA’s, it stands to reason that you’re also potentially interested in a similarly structured retirement vehicle – the Roth 401(k). A rather comprehensive discussion of the Roth 401(k) is available at MyRetirementBlog.com but here’s a brief recap.

A Roth IRA is to a Traditional IRA as a Roth 401(k) is a Traditional 401(k). Roth 401(k) contributions are not tax deductible, grow tax free, and share the same contribution limits as the “traditional” 401(k) it’s based off. The only tricky part about a Roth 401(k) is that any employer matching contribution goes into the “traditional” bucket and not all employers offer the Roth 401(k). In fact, not many at all offer it.

If you make a Traditional IRA contribution, you typically report it on your tax return in order to get a tax deduction. With a Roth IRA, since you won’t be getting a tax deduction, there’s no need for you to report the contribution on any returns. If you are tempted to contribution more than allowed, be aware that the financial institution holding your Roth IRA will still be reporting your contributions to the IRS and any extra will be penalized.

If you make a conversion, or make a nondeductible contribution to a Traditional IRA (because of 401k or income restrictions), or some other crazy scenario, you can use Form 8606 Nondeductible IRAs to report the activity.

If you want to make a qualified withdrawal from your Roth IRA as a first time homebuyer, you have to meet the following conditions (plus the five year test):

• Must be for a principal residence: The home you are buying has to be your place of principal residence and cannot be a vacation home or part-time home. It doesn’t have to be a traditional home, but it has to be home.
• IRA owner’s principal residence: If it’s your Roth IRA, it has to be your principal residence. You can’t buy a principal residence for someone else with your Roth IRA funds.
• First-time homebuyer: First time isn’t exactly what you think it is, you simply can’t have owned a principal residence during a 2-year period ending on the date of acquisition of your new principal residence. If you’re married, the same rule applies to your spouse.
• Must cover qualified acquisition costs: The amount has to go towards the acquisition, construction, or reconstruction of the principal residence and can include the usual settlement, financing, paperwork, processing fees, and other closing costs.
• $10,000 limit: You can only take out $10,000 (that’s a lifetime limit) and applies to the IRA owner. This means that two people, treating one place as a principal residence, could each withdraw $10,000 to go towards the house.
• Pay within 120 days: Once you withdraw the funds, you have to use it within 120 days. If you can’t, you can put it back in and then withdraw it later.

That’s it!

You can always withdraw your own contributions to a Roth IRA whenever you want without penalty. If you do elect to withdraw funds from your account, they come from the pool of your contributions first, then from your earnings. For example, if you contributed $5,000 this year, $5,000 last year, and the Roth IRA grew to be worth $12,000 ($2,000 in gains), the first $10,000 you wanted to withdraw from the fund would be tax free because it would come from your $10,000 in contributions over the last two years. Anything more and you’d be tapping into earnings. If you accidentally over-contribute and need to withdraw in order to compensate, you will take a small hit because you’ll be required to withdraw the portion of earnings attributable to the overage.

Withdrawal Rules

What if you want to withdraw earnings? If it is a qualified distribution, you can avoid paying taxes and penalties. If it’s not a qualified distribution, you might be hit with both. What defines a qualified distribution? Two things:

• Five year test: On January 1 of the fifth year after the first year you establish the Roth IRA, the five year test passes. There is no need for five actual years to pass, just that the year rolled through five digits.
• Reason / type of distribution: If you are taking a distribution and you’re over 59½, or it’s made to your beneficiary, or you become disabled, or you’re a qualified first time home-buyer… you’re in the clear!

If you satisfy those two rules, you’re okay. If you don’t, then unfortunately you’ll have to pay taxes and perhaps some penalties.

Converting your Traditional IRA to a Roth IRA is a very complicated question and one that many people will start asking soon when the IRA conversion loophole opens up in 2010. Whether or not you should convert your IRA comes down to several questions and they will help you decide which one is the right course of action.

Paying For The Conversion

When you convert the Traditional IRA over to the Roth IRA, you will have to pay taxes on the amount that you convert. The tax you pay will be your marginal tax rate and you can pay with IRA funds or with outside funds. If you can’t afford to pay for the conversion outside of the IRA, it’s generally accepted that you shouldn’t do the conversion. It’s better to have the larger dollar amount sitting tax-deferred than a smaller dollar amount sitting tax-free. This is also true because your tax profile now, while you are employed, is likely going to put you at a higher bracket than in the future, when you’ll be retired. This assumes that the tax brackets will remain relatively stable, which is never a certainty.

Partial Conversion

If you can only pay for part of the conversion outside of the IRA, certainly consider it. Also be aware that while you could be in the 15% bracket, the conversion itself may have a portion pushed into the 25% bracket. You can use partial conversions to avoid this.

Traditional IRA Was Non-Deductible

If you contributed to a Traditional IRA and were not eligible to deduct the contributions because of a 401(k), your conversion of those dollars will be free (because you already paid the tax). It behooves you to take advantage of the conversion if you would otherwise be ineligible.

There is a set of prohibited transactions when it comes to your IRA, be it Traditional or Roth. The prohibited transactions are, in general, described as “collectibles” such as art, rugs, beverages (scotch, wine, etc.), antiques, gems, coins, metals, stamps and things of that nature. Now, this is usually only a problem if you have a self-directed IRA because if you have a regular Roth IRA through a brokerage like Vanguard or Fidelity, they will usually only let you invest in the standard investments.

It’s important to follow these rules and to avoid prohibited transactions at all costs. If you fail to do so, the IRS could disqualify your IRA and that will have significant and severe consequences.

For the full list, review the pertinent sections of IRS Publication 590.