Roth IRA
Roth IRAs—named after the former Senate Finance Committee Chairman William V. Roth Jr.—have amazing tax benefits. While you don’t get to deduct the money you contribute to them, their greatest advantage is that when you make withdrawals, none of the money is taxable—neither your basis nor the earnings in your account! Instead of being tax-deferred accounts like regular IRAs, Roth IRA withdrawals are essentially tax-free. Of course you didn’t get a break on your deposit, but you’re not paying tax on your earnings. And they can stay tax-free and continue to grow for a long time. Unlike regular IRAs, you don’t have to start taking money out of your Roth after you turn age 70½. If you don’t need the money, you can leave it in the Roth IRA as long as you want.
Of course, such an amazing IRA is going to have limitations, and here they are.
• You can only contribute a limited amount into your Roth IRA, and that amount is reduced by any contributions you made to your regular IRA. In 2008, total IRA contributions were limited to $5,000. So if you put $3,000 in your regular IRA, you can only put $2,000 in your Roth IRA. Current tax law says that this limit will increase in increments of $500 each year, so in 2009 you can put $5,500 in your IRA and in 2010 you can deposit $6,000. Roth IRAs have the same catch-up provision as regular IRAs. If you’re over age 50, you can put in an extra $1,000.
• You can also contribute to a Roth IRA only if you make less than a certain amount of income. Tax penalties for contributing to a Roth IRA when you’re not eligible are steep. If your MAGI is below the bottom of the range in the following table, you can make the full Roth IRA contribution. If your income is inside the range, then your contribution amount is reduced—called phasing out your contribution. The phase-out is gradual, so once your income reaches the top of the range, you’re not eligible to contribute at all.
Tax Filing Status 2008 Income Phase-Out Range
Not all contributions to your Roth IRA have to come from annual contributions. You can also convert money from your Traditional IRA into a Roth IRA. You’re eligible to convert regular IRA money to your Roth in a tax year that your MAGI is greater than $100,000. This AGI limit applies to everyone except married taxpayers who are filing separately. If you’re filing single, married filing jointly, or filing as head of household, you can convert as long as your income is below $100,000. If you’re married filing separately, you can’t convert your IRA to a Roth IRA at all.
Full Account
Be careful to check the Roth IRA eligibility limits. The penalties are steep if you contribute when the rules prohibit it. Check your MAGI each year before you contribute to make sure you’re within the limit. Tax preparers won’t usually ask about Roth IRA eligibility, because that information doesn’t factor into your tax return in any way. Your investment company won’t usually ask, either, because all they need to know is what year you want the deposit applied for. Recently, I’ve found several accounts where the investor made the deposit without realizing he was ineligible. If this happens to you, you can take back the excess contribution before you file your taxes without a problem. If you’ve already filed your return, there’s a process to follow with the IRS to withdraw the excess and pay the penalties. An acquaintance once told me that his tax preparer recommended ignoring the mistake “because no one checks.” That’s bad advice! Straighten out your mistake, even by paying a penalty, so you won’t have the threat of bigger penalties later hanging over your head.
Check the resources section at the back of the book for online calculators to help you decide whether a Roth conversion makes sense for you. You’ll owe income taxes on the amount of money you convert because all Roth contributions must be with after-tax money. Even after this additional cost, conversion may still be a good idea if you have more than 10 years before you’ll start withdrawals; you want to defer withdrawals well past age 70; or you believe your tax bracket in retirement will be at least as high as while you’re working. We have more on how to decide whether to convert your IRA to a Roth in Chapter 10.
You can withdraw money you contributed to your Roth IRA at any time. After all, you contributed it after-tax, so there’s no tax on the withdrawal. In order for your or your heir’s withdrawals to be tax- and penalty-free, they must qualify by meeting at least one of these key tests plus an additional five-year rule:
• Made after you turn age 59½
• Made after you died
• Made after you become disabled, as the IRS defines it
• Made to pay for permitted first-time home-buyer expenses
The five-year rule is applied differently to earnings from Roth IRA contributions and earnings from Roth conversions. The rule for contributions says that your eventual withdrawal isn’t qualified unless you’ve waited to withdraw for at least five tax years since your first deposit. That means if you make your first Roth contribution in the 2008 tax year, you will meet your five-year rule by the end of 2013. The five-year rule only applies once, so once you’ve run the five-year course with your first Roth IRA contribution, you don’t have to worry about waiting for subsequent contributions to age.
Nest Eggs
You may not have to wait five full calendar years to make a Roth withdrawal. Remember that tax years are the same as calendar years, but you get a grace period until tax day of the following year to make your Roth IRA contribution. So if you make your first Roth IRA contribution April 15, 2009, for the 2008 tax year, you’ll meet your five-year rule December 31, 2013, not quite a full five calendar years later.
Roth conversions are a little trickier. Each conversion starts its own five-year rule countdown, but if you first opened your Roth account with a conversion, the conversion can also start the one-time clock for contributions.
The Least You Need to Know
• April 15, or tax day, is the deadline to make IRA contributions.
• You must start making withdrawals at age 70½ from your IRAs, including Traditional, SEP, and SIMPLE but excluding Roth.
• Eligibility rules may change each year, so check the rules each year before contributing to your account.
• Keep track of nondeductible IRA contributions on tax form 8606.
• Don’t use investments with high fees in your IRA.
• The annual contribution limit for IRAs applies to all your IRA accounts combined, including Roths.
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