Yep, that’s right, a Roth IRA. Most college graduates probably aren’t thinking about retirement right now, in fact they’re just looking forward a relaxing summer followed by their first paycheck. However, as a responsible adult (ha!) you may consider giving that graduate a Roth IRA and get them started on saving for their future.

Earned Income. The rule with contributions is that a person has to earn as much “earned income” in order to contribute that to their Roth IRA. The dollar they earn doesn’t necessarily have to be the dollar they contribute so as long as your graduate will be earning money, you can probably open a Roth IRA on their behalf. If the graduate has a job, chances are he or she will have sufficient earned income to cover your Roth IRA contribution (the $5,000 contribution limit for this year).

Another side benefit of this gift is that it helps the graduate recognize the importance of retirement and lets them know about the Roth IRA, if they don’t know about it already.

The second proposed change involves introducing Roth IRA as an option in the TSP which would result in significant savings for deployed troops since they do not pay taxes on their earnings or bonuses while they are in war zones. With a Roth IRA, you contribute after-tax dollars and appreciation is tax free. Troops in a combat zone are in the 0% tax bracket, so they benefit tremendously from the Roth IRA option.

Those troops who are not in combat zones also benefit from the Roth IRA option because it gives them tax diversification.

DoD backs automatic TSP enrollments [Air Force Times]

• 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).

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.

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 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.

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.

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.