Roth IRA Explained

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.

We at Roth IRA Explained want to be a helpful and informative resource for novice and seasoned investors looking to understand all the basics of Roth IRAs, all the nuances of Roth IRAs, and all the complicated aspects of Roth IRAs – all the things that you probably wanted to know but simply couldn’t glean by reading other more complicated sites out there. I’m a regular person like you, I am not an expert investor, I’m not a tax expert, and I am not a lawyer. The things that I write may be incorrect, I might misinterpret some things, but rest assured if and when I find any errors, I seek to correct as quickly as possible.

Hopefully you will bookmark this site and turn to it whenever you have any questions!