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 ($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 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.

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.

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.

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.

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.