Roth IRA Explained

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 ($110,000 - $101,000) / $15,000 (the range) = 0.6. Then take 0.6 x $5,000 = $3,000. Your contribution limit is $3,000.

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.

When you contribute funds to a Roth IRA, you probably only expect to get any tax benefits on the other side of the equation, when you’re in retirement. However, did you know that you can get a tax credit for contributing to a Roth IRA? It’s true, you can get a tax credit for contributing to a Roth IRA, or any retirement plan, is you claim the credit and if you satisfy the requirements of the credit. The government wants you to save for your retirement and incentivizes it with these retirement tax credits.

The requirements are:

• You must have turned 18 during the tax year (so the last people who can claim it are those with December 31st birthdays),
• For 5 months out of the year you couldn’t have been a full-time student,
• You aren’t a dependent on someone else’s return,
• And, here’s the big one, your adjusted gross income is less than $26,500 unless you’re married filing jointly (limit is $53,000), head of household ($39,750)) - these figures are for 2007, so come back later in the year once they release the new limits for 2008.

If you qualify, the tax credit lets you get back to 50% of your contribution

How much can you get? You can get a 50% credit if you have adjusted gross income up to $16k ($32k for married filing jointly and $24k for head of household), a 20% credit if you have income up to $34,500 ($28,875 for MFJ and $17,250 for HOH), and only a 10% credit if you’re above those limits but under $26,500 ($53k for MFJ and $39,750 for HOH).

How do you claim it? Fill out Form 8880 and submit it with your 1040 return. This is easy to miss with things like a Roth IRA because it’s not listed anywhere (whereas your 401k usually appears on your tax return).

So, if you qualify, be sure to request it. If you qualified for it in 2007 and never claimed it, be sure to amend your return with a 1040X and get what is rightfully yours!

If you are married but personally earn no income, your spouse can contribute to something known as a Spousal IRA as long as he or she earns enough money to cover both contributions (if they opt for their own contribution). This is best explained by an example of how the Spousal IRA works and in our example we will assume you are contributing to a Roth IRA.

Example 1: One spouse earns $60,000 a year, the other earns $0. Since the joint return will show income of $60,000, you can contribute $5000 to each of your Roth IRAs without any problems whatsoever.

Example 2: One spouse earns $8,000 a year, the other earns $0. In this case, there is not enough earned income to cover two Roth IRA maximum contributions so you’ll have to split the $8,000 between the two accounts. You can do $5,000 in one and $3,000 in the other, or $4k each, but you cannot exceed contributions of $8,000 because that’s all you have.

Eaxmple 3: One spouse earns $180,000 a year, the other earns $0. In this case, since earnings are above the 2008 Roth IRA contribution phaseouts, neither of you can contribute to your Roth IRA.

For more information, please consult a professional financial planner for your particular situation.

At one point or another you probably wondered whether you should contribute to a Roth IRA or a Traditional IRA. While I can’t tell you which one is best for you, I can tell you my own thought process and hope you can use it to decide which one is better for you.

For me, I had access to a 401(k) through my employer. A 401(k) is like a Traditional IRA, it’s a tax deferred retirement option, though I can get an employer match for my contributions. In 2008, I can contribute $15,500 towards the 401(k), far exceeding the $5,000 I can put in a Traditional IRA. Another consideration was that because I had access to a 401(k) and because my income was above the deductibility ceiling, I couldn’t deduct Traditional IRA contributions. Even if I could, I still would pick a Roth IRA because I would rather diversify my tax profile and put $15,500 (or less) tax-deferred in a 401(k) and then $5,000 tax-free in a Roth IRA.

The Roth IRA is best for when you think your current marginal tax rate will be lower than your retirement tax rate. That makes it idea for young professionals, teenagers, and new workers because you likely will earn more as you grow older. If you earn more later on, your tax rate will increase, by protecting those assets in a Roth IRA, you can shield them from the higher tax rates.

Roth IRA isn’t necessarily better than a Traditional IRA in all cases, it was simply better for me.

Here is another post on My Retirement Blog discussing how to choose between Roth IRAs and Traditional IRAs.

This rule applies for any of the IRAs, from SEP-IRAs to Traditional to whatever, but basically you can contribute to any particular year’s IRA from January 1 of that year to the IRS income tax filing deadline of that year, usually April 15 of the following year. Sometimes that date is extended because of holidays for certain areas of the country but generally it holds true.

For example, for 2006, you could contribute to a Roth IRA as early as January 1st, 2006 and as late as April 17th, 2007 (15th was a Sunday, 16th was a holiday in the New England states). That meant anytime in the first quarter or so of 2006, you could contribute to 2006 or 2005 - making it crucially important that you specify, on your contribution, what year you were contributing to. By default, brokerages and financial institutions will default to the calendar year. So if you write nothing and send in a check on Feb. 1st, 2006, they will count the IRA contribution against your 2006 limit.

That’s right, you can retire with $2,583,307.74 in your Roth IRA if you start early enough, have a bit of luck on your side, and stick with it for forty years. It’s a long time, granted, and there is a chance you won’t be able to contribute to your Roth IRA for 40 years, because of income restrictions; but if you do, there is a handsome tax-free rewards for you at the end of the rainbow. If you contribute $4,000 a year and your Roth IRA investments appreciate at a rate of 11% each year, the following table shows you exactly how much you will have after how many years.

Two and a half million dollars… just for a little discipline and some luck. Are you ready to go after it?

All IRAs share contribution limits - from Traditional to Roth to SEP to any other IRA out there that may exist. If you have no income restrictions, then the limit is $4,000 for 2007, $5,000 if you’re 50 and over; so if you contribute $1,000 to a SEP-IRA as an employee, then you’re only allowed to contribute $3,000 to your Roth IRA.

Most of the time someone will contribute entirely to one type of IRA but sometimes you will see someone contribute to different types depending on their situation because of the different limitation rules of each IRA. Someone who is restricted to a maximum of $2,000 into their Roth IRA may opt to contribute the remaining $2,000 to a Traditional IRA, which has no contribution limit (its limits are for deductibility of those contributions).

If you wanted to convert a Traditional IRA to a Roth IRA today and you earned more than $100,000, you’d be out of luck. However, because of Tax Increase Prevention and Reconciliation Act of 2005 signed into law on May 17, 2006, you can wait until 2010 to do the conversion when the $100,000 income test no longer applies. If you do make the conversion in 2010, you can push half the taxable converted amount taxed in 2011 and half in 2012 (just to help ease the pain).

There is still plenty of time for Congress to pass acts that close this loophole since 2010 is over two years away (though Congress doesn’t move that fast), but until then this is a great way to get around the Roth IRA contribution limits.

If you participate in an employer sponsored retirement plan (401k, 403b, etc.), then you’ll probably know that any contributions to a Traditional IRA are likely not tax deductible (or at least phased out partially) because of income restrictions. However, by this loophole, you can then convert those over to a Roth IRA free of charge because you’ve already paid the tax on them. You would only have to pay the taxes on the gains you’ve made in that time. For example, if you put in $4,000 into a Traditional IRA and could deduct nothing. If by 2010, you see that your IRA is now worth $5,000, you could convert and only pay taxes on the $1,000 of gains, not the full $5,000. This plan is not without risk because Congress can always put the loophole back. Plus, remember to keep all your documentation that your contributions were not deducted.

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!

How much can you contribute each year to your Roth IRA? That depends on how much income you’ve earned that year, if you are below the annual contribution limit then your maximum contribution amount is your earned income. If your annual earned income is above the contribution limit, explained below, then the limit is specified by law to be $4000 in 2007 and $5000 in 2008.

Here are the contribution limits for 2007 and beyond:

After 2008, the contribution limits will increase in $500 increments in line with inflation.

In addition to the base contribution limit, there is a catch-up contribution provision of $1,000 if you are 50 and over.

Did you know that not everyone can contribute to a Roth IRA? Yep, that’s right, not only do you need to earn income, you can’t earn too much! For a single filer, if your adjusted gross income is between $95,000 and $110,000 then you can’t contribute the full $4000, your maximum contribution is some amount less than that.

Contribution Limits

How much you can contribute is linearly related to that phaseout range. For example, if you are Married Filing Jointly and earn $155,000, you are permitted 50% of the Roth IRA contribution, or $2,000 annually.

There are two special rules. The first is that the increments are in units of $10, rounding up at all times. A limit of $1201 means you can contribute up to $1210 each year. The second rule is that the minimum contribution, above $0, is $200. So if you calculate that you can only contribute $100 each year, you actually can raise that to $200.