Roth IRA Explained

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.