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).

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.

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.

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.

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.

• 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).

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 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.

• 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!

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.