Roth IRA Explained

Roth IRA is a great vehicle if you’re eligible. Unfortunately, there are certain income restrictions that may prevent you from participating. There is both a lower limit and a higher “range” that may exclude you from participating in this tax-free investment vehicle popularized in the last decade.

Lower Income Limit

The lower income limit refers to how you must earn income in order to contribute it to a Roth IRA. The 2008 annual contribution limit for Roth IRAs is $5,000, with a $1,000 catch-up contribution for those aged 50 and above. Every dollar you contribute must have been earned in that year, so if your tax return filing says you earned $500 (after taxes) this year then you may only contribute $500 this year.

The $500 you contribute does not necessarily have to be the $500 you earned. One example is for children. If they earned $500 but spent it on candy, parents can elect to give them $500 to contribute.

Upper Income Range

There is a phase-out range for the upper limit, where the $5,000 contribution limit is slowly phased out in $20 increments. The phase for Single tax filers begins at $101,000 and ends at $116,000. If you earn less than $101,000 then you can contribute the full $5,000. If you earned more than $116,000 then you can’t contribute anything. Within that $101k to $116k, simply figure out how far into the range you are and apply that percentage to the contribution limit – rounding up to the nearest $20. The limits are different for other filing statuses (Traditional and Roth IRA Contribution Limits).

With all the chaos in the financial markets, you’re probably a little concerned as to what will happen to your Roth IRA or Traditional IRA in the event your bank goes under. Fortunately, you don’t have to be as long as you have less than $250,000 in your account at a particular bank. Effective April 1st, 2006, the coverage limits for retirement accounts, which include traditional and Roth IRAs, was increased from $100,000 (the same as deposit accounts) to the current level of $250,000.

The other retirement accounts included are self-directed Keogh accounts, 457 Plans for state governemnt employees, and employer-sponsored “defined contribution plans” like 401(k)s.

Remember, this is protection again bank failure and does not cover the value of your assets. For example, if you bought a particular stock and it loses value, FDIC does not protect you against that (that would be completely unreasonable). However, if your bank does go under and it was the administrator of a 401(k) plan, you’d be protected up to $250,000.

One of the most popular questions I get is whether a teenager can get a Roth IRA and the answer is yes, as long as they have income.

The rule for the Roth IRA is that you can contribute based on how much you’ve earned in a year. If you’ve earned $2,000, you can contribute up to $2000 (after taxes) to your Roth IRA. If you earned more than $5,000 then the limit for the Roth is $5000.

When it comes to teenagers, you will want to open a custodial account at a brokerage. Since they’re under the age of 18, they can’t open their own account but you can open one on their behalf, you are their custodian, which is effectively the same thing. For all intents and purposes, the account is theirs but you are watching over them to make sure they don’t make any mistakes, right?

Remember, they can only contribute as much as they declare on their taxes. So, if they’ve been mowing lawns and don’t intend to claim that income on a Form 1040, they can’t put that towards their Roth IRA. Technically, your children have to claim that income but if they don’t, they can’t use it towards their Roth IRA.

I met with my accountant this week and one of the things we discussed was retirement. I told him that I was going to try to take advantage of the 2010 Roth IRA conversion loophole by contributing to a non-deductible Traditional IRA starting this year (2008). A quick recap on the rule is that right now you have to earn under a certain amount to be eligible to convert, in 2010 that rule disappears and anyone can do the conversion. With respect to taxes, you pay income tax on the amount you convert and that amount now enters the Roth IRA world.

So, the recommendation he gave me was that if I’m going to do this, I need to keep my non-deductible Traditional IRAs segregated from my other Traditional IRAs. Right now I have a Rollover IRA at Vanguard so I will want to keep that one separate from the non-deductible one. When it comes to do the conversion, I won’t have any headaches separating the two. When I do the conversion, I pay no tax because I never deducted the contribution in the first place.

What happens if I don’t separate them? You have some minor headaches. The conversion process allows you to pick how much you want to convert. You can convert the whole thing or convert a part. When you mix the deductible and the non-deductible, you make things a little more chaotic. If you opt to convert only 50%, you can’t convert just the non-deductible part, you’ll have to convert based on the weightings. This is better explained with an example.

Let’s say your IRA has $8,000 in deductible IRA contributions and $2,000 of non-deductible IRA contributions. If you elect to convert 50% of that IRA to a Roth IRA, you’ll have to take $4,000 of the deductible contribution and $1,000 of the non-deductible. You can’t choose to take $2,000 of the non-deductible and $3,000 of the deductible IRA. If you keep them in separate accounts, you can convert them independently and thus avoid this problem.

If you’re thinking about converting your Traditional IRAs into Roth IRAs, paying the taxes, and then watching your earnings grow tax free, great! If you’re also taking Social Security benefits, you might want to take a step back and talk to a professional tax accountant before you do that conversion.

When you convert a Traditional IRA into a Roth IRA, you declare that converted value as income. As you probably now know, that income can affect your Social Security benefit payout for the year. If your total worldwide income, including tax-exempt income and half of Social Security, exceeds a certain amount, then your Social Security benefit may be subject to taxes.

For Single filers and Head of Household, the first level is at $25k. For Married Filing Jointly, the first level is at $32k. If your total income, including tax-exempt and half of SS, then 0% of your benefit is taxed. If, as a Single or HoH, you earn between $25k and $34k ($32k and $44k for MFJ), then you will pay taxes on 85% of your SS benefit. If you earn more than $34k (or $44k), then 85% of your SS benefit is taxable.

It’s something to factor in if you are considering converting your IRAs.

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 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.