Roth IRAs
Course Section
Roth IRAs offer a slight twist on the traditional IRA. There are differences in the tax advantages and who can open an account. The most attractive parts of a Roth IRA are that your money grows tax-free, and your money is withdrawn without paying federal taxes. Here are some of the main features of a Roth IRA.
Contribution Rules
Unlike traditional IRAs, you can't deduct contributions to a Roth IRA from your income taxes. Instead, you contribute money that has already been subject to taxation. You can contribute up to $4,000 (non-deductible) a year of earned income into the account. If you're 50 or older, you can also make an additional "catch up contribution" of up to $1,000 in 2006.
Here are some other rules:
- You can contribute to a Roth IRA as long as you have income from work or alimony.
- Your annual contributions are not tax-deductible (as they would be if contributed to a traditional IRA)
- No matter how old you are, you can keep contributing money to a Roth IRA as long as you earn income.
Eligibility
To qualify for the maximum Roth contribution in 2005, your modified adjusted gross income (AGI) must be less than $95,000 (single). If it's between $95,000 and $110,000 (single), you will qualify for partial contributions. For married couples filing jointly, your modified AGI must be less than $150,000 to qualify for full contributions. If it's between $150,000 and $160,000, you will qualify for partial contributions.
Making Investments
The IRA is not an investment itself. It's an account into which you invest
your money. You can invest the money you contribute in stocks, bonds, bank CDs,
mutual funds, and other investments, including real estate. Pick investments
that match your retirement goals.
Money Grows Tax-Free
Money that you put into a Roth IRA grows tax-free. This means that everything
you earn stays in the account to continue earning more money over the years.
The more years you leave the money in, the more your money can accumulate and
grow.
Because your money grows tax-free in a Roth IRA, don't invest in something that already grows tax-free in a regular account, such as a municipal bond. Instead, choose investments that would be taxed if in a regular account, such as a stock mutual fund.
Withdrawals are Tax-Free
A great feature of Roth IRAs is that you can withdraw contributions tax-free,
once you have the account for 5 years and are at least 59 1/2 years old. Unlike
a traditional IRA, however, you aren't required to withdraw money
from the account (or pay additional taxes) once you turn 70 1/2. In other
words, the account can be held until death and passed on tax-free to a spouse,
children, or other heirs.
Penalties
There is no early withdrawal penalty on the money you contributed to a Roth IRA. But there may be a penalty for early distributions from the Roth IRA unless you meet the same exceptions that apply to Traditional IRAs (see the comparative table). For example, you may withdraw money without penalty to pay health insurance premiums after losing your job.
Converting to a Roth IRA
For some people, Roth IRAs provide better savings vehicles than traditional
IRAs. You may be able to convert some or all of your IRA money into a Roth IRA.
It's a two-step process. First, you must withdraw your money from the
Traditional IRA and pay taxes on the withdrawn money. Then, you can use the
remainder of the money to open a new Roth IRA.
The entire amount converted is subject to income taxes. In other words, the amount converted is added to your other income for the year and taxes are due on that new total gross amount at whatever tax bracket rate you end up in. Note: You cannot withdraw money from the Roth IRA to pay the taxes.
Transfers can be tricky, so consult with a financial expert to make sure such a conversion is beneficial to you.
Take Action
- To find out about contribution levels, which type of IRA may be best for you, and more about converting from a traditional IRA to a Roth IRA, go to http://screen.morningstar.com/ira/iracalculator.html.
- You can find additional Roth IRA calculators at www.moneychimp.com/articles/rothira/rothcalc.htm and http://moneycentral.msn.com/investor/calcs/n_roth/main.asp.
Additional Resources
General information about Roth IRAs is available at www.irs.gov.
This column is meant to provide general financial information; it is not meant to substitute for, or to supersede, professional or legal advice.
Note: The content areas in this material are believed to be current as of this printing, but, over time, legislative and regulatory changes, as well as new developments, may date this material.
