Roth IRA Explained

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.