Roth IRA

A Roth IRA is an Individual Retirement Account (IRA) allowed under the tax law of the United States. Named for its chief legislative sponsor, Senator William Roth of Delaware, a Roth IRA differs in several significant ways from other IRAs.

Overview

Established in 1998 (Public Law 105-34), a Roth IRA can invest in securities, usually common stocks or mutual funds (although other investments, including derivatives, notes, certificates of deposit, and real estate are possible). As with all IRAs, there are specific eligibility and filing status requirements mandated by the Internal Revenue Service. A Roth IRA's main advantage is its tax structure. Depending on with whom a Roth IRA is set up, it can be managed in creative ways, including investments in non-typical assets (Self-Directed IRA).

The total contributions allowed per year to all IRAs are limited as seen below (this total may be split up between any number of Traditional and Roth IRAs. In the case of a married couple, each spouse may contribute the amount listed):

	Age 49 and Below	Age 50 and Above
1998–2001	$2,000	$2,000
2002–2004	$3,000	$3,500
2005	$4,000	$4,500
2006–2007	$4,000	$5,000
2008*	$5,000	$6,000

*Starting in 2009, contribution limits will increase in $500 increments based on inflation.

Differences from a traditional IRA

In contrast to a traditional IRA, contributions to a Roth IRA are not tax-deductible. Withdrawals are tax-free. An advantage of the Roth IRA over a traditional IRA is that there are fewer withdrawal restrictions and requirements. Transactions inside the Roth IRA account (including capital gains, dividends, and interest) do not incur a current tax liability. Withdrawals are generally tax free when the account has been opened for at least 5 years and the owner's age is at least 59 ½.

Advantages

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• If there is money in the Roth IRA due to conversion from a Traditional IRA, the Roth IRA owner may withdraw up to the total of the converted amount, as long as the "seasoning" period has passed on the converted funds (currently, five years).
• Withdrawals of earnings are tax-free once the participant reaches age 59.5 or becomes disabled, so long as the account is "seasoned" (established for five or more years).
• Up to $10,000 in earnings withdrawals are considered qualified (tax-free) if the money is used to acquire a principal residence. This house must be acquired by the Roth IRA owner, their spouse, or their lineal ancestors and descendants. The owner or qualified relative who receives the "first time homeowner" distribution must not have owned a home in the previous 24 months.
• If a Roth IRA owner dies, and his/her spouse becomes the sole beneficiary of that Roth IRA while also owning a separate Roth IRA, the spouse is permitted to combine the two Roth IRAs into a single account without penalty.
• If the Roth IRA owner expects their tax bracket after retirement to be higher than before retirement, there is a tax advantage to making contributions to a Roth IRA over a traditional IRA or similar vehicle. There is no current tax deduction, but money going into the Roth IRA is taxed at the lower current rate, and will not be taxed at the higher future rate when it comes out of the Roth IRA. If a taxpayer is currently in the 15% tax bracket, then a $1,000 contribution to a traditional IRA would provide a $150 reduction in current-year tax liability. If that taxpayer were in the 30% tax bracket upon retirement, $1000 of traditional IRA distributions would incur $300 in taxes. Therefore, the person would pay twice as much for after retirement income as he received in tax benefits from the traditional IRA deduction (and since gains are compounded, this comparison is valid). Therefore, the Roth IRA offers a specific advantage where a person will retire in a higher tax bracket than that used during their pre-retirement years.
• The Roth IRA does not require distributions based on age. All other tax-deferred retirement plans, including the related Roth 401(k), require withdrawals to begin by April 1 of the calendar year after the owner reaches age 70½, however, beneficiaries who inherited Roth IRAs are subject to the minimum distribution rules;.
• Earnings in a Roth IRA are not taxed if withdrawn after the "seasoning" period. Earnings in a Traditional IRA are taxed as Ordinary Income even if the monies were invested in stocks or mutual funds. It is interesting to note that when stocks or mutual funds are held outside of a 401(k), the long term capital gains are only taxed at 15%. Most middle class Americans will pay at least 28% of the capital gains earned in a traditional IRA as federal income tax. (Though in a traditional IRA, this higher tax rate is a quid pro quo for the deduction taken against ordinary income when putting money into the IRA.)

Disadvantages

• The main disadvantage of a Roth IRA (when compared to a traditional IRA) is that contributions are not tax-deductible. If one contributes $1000 to a traditional IRA while in a high tax bracket, one can often receive a tax deduction, substantially reducing the initial cost of contributing (or, potentially, allowing someone without much disposable income to shelter more income). This is not the case for the Roth IRA. The money in a traditional IRA is taxed once it is withdrawn at retirement.
• With a Roth IRA, there are heavy penalties for early withdrawals of earnings (withdrawals up to the total of contributions + conversions are tax-free). An unqualified withdrawal of earnings will result in federal income tax plus a ten-percent penalty on the amount. Fortunately there are many exceptions, such as buying a first home and paying qualified educational expenses.
• The perceived tax benefit may never be realized, i.e., one might not live to retirement or much beyond, in which case, the tax structure of a Roth only serves to reduce an estate that may not have been subject to tax. One must live until one's Roth IRA contributions have been withdrawn and exhausted to fully realize the tax benefit. Whereas, with a traditional IRA, tax might never be collected at all, i.e., if one dies prior to retirement with an estate below the tax threshold, or goes into retirement with income below the tax threshold. Although heirs will have to pay taxes on withdrawals from traditional IRA accounts they inherit, and must continue to take mandatory distributions (although it will be based on their life expectancy). It is also possible that tax laws may change by the time one reaches retirement age.

Eligibility

Income limits

As with many tools that offer tax advantages, Congress has limited who can contribute to a Roth IRA, based upon income. A taxpayer can only contribute the maximum amount listed at the top of the page if their Modified Adjusted Gross Income (MAGI) is below a certain level (the bottom of the range shown below). Otherwise, a phase-out of allowed contributions runs throughout the MAGI ranges shown below. Once MAGI hits the top of the range, no contribution is allowed at all. The ranges, for 2007, are:

• Single filers: Up to $99,000 (to qualify for a full contribution); $99,000-$114,000 (to be eligible for a partial contribution)
• Joint filers: Up to $156,000 (to qualify for a full contribution); $156,000-$166,000 (to be eligible for a partial contribution)
• Married filing separately (if the couple lived together for any part of the year): $0 (to qualify for a full contribution); $0-$10,000 (to be eligible for a partial contribution).

The lower number represents the point at which the taxpayer is no longer allowed to contribute the maximum yearly contribution. The upper number is the point as of which the taxpayer is no longer allowed to contribute at all. Note that people who are married and living together, but who file separately, are only allowed to contribute a relatively small amount.

However, once a Roth IRA is established, the balance in the account remains tax-sheltered, even if the taxpayer's income rises above the threshold. (The thresholds are just for annual eligibility to contribute, not for eligibility to maintain an account.)

The ranges, for 2008, are:

• Single filers: Up to $101,000 (to qualify for a full contribution); $101,000-$116,000 (to be eligible for a partial contribution)
• Joint filers: Up to $159,000 (to qualify for a full contribution); $159,000-$169,000 (to be eligible for a partial contribution)

Conversion limit

Currently only taxpayers with MAGI of less than $100,000 in the year of conversion, regardless of tax filing status, may convert from a traditional IRA to a Roth IRA (the converted amount is not included in MAGI). TIPRA 2005 eliminates the MAGI limit on conversions starting in 2010. Thus regardless of income, contributions can be made to a traditional IRA in previous years, and then rolled over in 2010.

See also

• 401(k) IRA matrix - 401k & IRA comparisons (401k vs Roth 401k vs Traditional IRA vs Roth IRA)

External links

• IRS Publication 590 (IRAs) (pdf)
• IRS ROTH IRA Publication 590 (HTML)
• Guide to Roth Retirement Accounts (extensive online guide)
• Roth IRA Conversions [1] (pdf)
• Roth IRA Funds Calculator
• Roth IRA at Retirement Planning Updates