Although many of you are familiar with Roth Individual Retirement Accounts (Roth IRAs) I would like to review some important facts that are often misunderstood. To maximize the benefits of this account it is important to have accurate information.
What they are
Created by the Taxpayer Relief Act of 1997, Roth IRAs were named after former Senate Finance Committee Chairman William Roth, Jr. Unlike traditional IRAs, contributions to a Roth IRA are never tax-deductible. However, qualified withdrawals from your Roth IRA are tax-free.
How they are funded
Taxpayers are eligible for a Roth IRA if they have earned wages within certain limits set by Congress. If you are a single taxpayer and your modified adjusted gross income (MAGI) is less than $99,000 ($156,000 for joint filers) you may contribute $4,000 a year ($5,000 if you are age 50+). If your income is over this amount your eligibility begins to phase out. Single taxpayers with income up to $114,000 ($166,000 for joint filers) are eligible for a partial contribution. Once your income exceeds these limits you are not eligible.
If you have an existing IRA (AKA Traditional IRA) you can still maintain it along with your Roth IRA. You can even make contributions to both in the same year so long as the sums of your contributions don’t exceed the maximum contribution limits.
Roth IRAs can also be funded by "converting" a traditional IRA. To qualify for this method a taxpayer's modified adjusted gross income (MAGI) must be less than $100,000 (same if single or married). Last year, however, a new law was passed that will allow anyone regardless of income level to convert in the year 2010 and beyond. To take advantage of that opportunity, more people are now making nondeductible traditional IRA contributions so that they can build up the amount they will be able to convert in the future.
Upon conversion, you will owe ordinary income taxes on the sum of the account's deductible contributions and earnings (the money that has not been taxed before). It is recommended that the taxes due be paid from a separate account. If you have to use money in your traditional IRA to pay the tax on the conversion, it will be considered an early withdrawal (assuming you are under age 59½) and you will owe a 10% penalty on it.
How you get your money out
Contributions made into a Roth IRA may always be withdrawn without paying income tax. After all, you paid the tax on that money before it was contributed to the Roth IRA. Conveniently, the I.R.S. uses the "first in first out" (FIFO) accounting method giving you the ability to withdrawal your contributions and leave the earnings in the account.
Once you begin tapping into the account’s earnings you must be sure the withdrawal is "qualified" otherwise you will pay taxes and penalties. For the earnings inside your Roth to become qualified they must meet two requirements. First, your Roth IRA must meet the "five-year test." In other words it must be at least five years since you opened the account with your first contribution. Second, one of the following conditions must apply:
- You've attained age 59½
- You're a beneficiary of the IRA
- You're disabled
- You're eligible for a qualified first-time homebuyer withdrawal of up to $10,000
If your withdrawal does not meet these requirements it is considered to be "nonqualified." There are ordering rules for taking nonqualified distributions and it is likely that you will be subject to ordinary income taxes, plus an additional ten percent early distribution tax.
If the distribution is a result of the account holder's death beneficiaries must determine whether or not the distributions are qualified. If the owner of a Roth IRA dies before the end of:
- The 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for the owner's benefit, or
- The 5-year period starting with the year of a conversion contribution from a traditional IRA to a Roth IRA,
each type of contribution is divided among multiple beneficiaries according to the pro-rata share of each.
If a distribution to a beneficiary is nonqualified, it is generally includible in the beneficiary's gross income in the same manner as it would have been included in the owner's income had it been distributed to the IRA owner when he or she was alive.
