Roth IRA Explained

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!

All IRAs share contribution limits – from Traditional to Roth to SEP to any other IRA out there that may exist. If you have no income restrictions, then the limit is $4,000 for 2007, $5,000 if you’re 50 and over; so if you contribute $1,000 to a SEP-IRA as an employee, then you’re only allowed to contribute $3,000 to your Roth IRA.

Most of the time someone will contribute entirely to one type of IRA but sometimes you will see someone contribute to different types depending on their situation because of the different limitation rules of each IRA. Someone who is restricted to a maximum of $2,000 into their Roth IRA may opt to contribute the remaining $2,000 to a Traditional IRA, which has no contribution limit (its limits are for deductibility of those contributions).

If you wanted to convert a Traditional IRA to a Roth IRA today and you earned more than $100,000, you’d be out of luck. However, because of Tax Increase Prevention and Reconciliation Act of 2005 signed into law on May 17, 2006, you can wait until 2010 to do the conversion when the $100,000 income test no longer applies. If you do make the conversion in 2010, you can push half the taxable converted amount taxed in 2011 and half in 2012 (just to help ease the pain).

There is still plenty of time for Congress to pass acts that close this loophole since 2010 is over two years away (though Congress doesn’t move that fast), but until then this is a great way to get around the Roth IRA contribution limits.

If you participate in an employer sponsored retirement plan (401k, 403b, etc.), then you’ll probably know that any contributions to a Traditional IRA are likely not tax deductible (or at least phased out partially) because of income restrictions. However, by this loophole, you can then convert those over to a Roth IRA free of charge because you’ve already paid the tax on them. You would only have to pay the taxes on the gains you’ve made in that time. For example, if you put in $4,000 into a Traditional IRA and could deduct nothing. If by 2010, you see that your IRA is now worth $5,000, you could convert and only pay taxes on the $1,000 of gains, not the full $5,000. This plan is not without risk because Congress can always put the loophole back. Plus, remember to keep all your documentation that your contributions were not deducted.