Roth IRA Rules

Roth IRA Rules

Roth IRA Rules

If you’ve been a frequent visitor to this blog, then you probably know how much I’m in love with the Roth IRA. The Roth IRA is has the most potential benefit to future retirees than any other retirement planning tool. Although the concept of tax-free money is easy to digest, the rules revolving around the Roth IRA can get tricky.

Why You Want to Open a Roth IRA

The quick answer is tax-free money.  But it’s so much more than that. You can use a Roth IRA  to maximize the amount of wealth you can generate.  Who doesn’t want to maximize the amount of you wealth you generate over time?  Am I trying to tell you that depositing all your retirement savings into a Roth IRA?  Well, maybe not everything, but as much as you can.

Opening a Roth IRA is easier than crossing the street or buttering a slice of bread. In fact, I’ve even claimed that the Roth IRA is the greatest thing since sliced bread.

Traditional IRA vs. Roth IRA

Let’s start with a quick explanation of Roth IRA vs traditional retirement accounts (this can be either an IRA or 401(k) as each offer the Roth variant). A traditional account permits you to take a tax deduction for deposits going into the account, in which the money would grow, tax-deferred, and taxed upon withdrawal at your prevailing marginal rate. The Roth account is a bit of a mirror image of this, the deposits are made with post-tax money, but both the growth and subsequent withdrawals are made tax free. In a sense, the decision comes down to one question – will you be in a higher tax rate at withdrawal time?

Traditional IRARoth IRA
EligibilityAny person with earned income who is under 70-1/2.

A nonworking spouse under age 70-1/2 who files a joint return that includes earned income.

Single filer with modified adjusted gross income (MAGI) of:

* $105,000 or less — full contribution
* $105,001–119,999 — partial contribution
* $120,000 or more — not eligible

Joint filers with MAGI of:

* $167,000 or less — full contribution
* $167,001–176,999 — partial contribution
* $177,000 or more — not eligible

Married, filing separately with MAGI of:

* $0–$9,999 — partial contribution
* $10,000 or more — not eligible
Maximum Annual ContributionsThe total contribution to all your IRAs in 2009 and 2010 is $5,000 or 100% of your compensation, whichever is less. If you’re age 50 or older, you can make an additional contribution of $1,000, for a total of $6,000 in 2009 and 2010.Same as traditional IRA, subject to phase-out range depending on modified adjusted gross income (MAGI) as explained above in Who is eligible.
Deductible Contributions2010

Single filer, retirement plan participant with modified adjusted gross income (MAGI) of:

* $56,000 or less — fully deductible
* $56,001–65,999 — partially deductible
* $66,000 or more — nondeductible

Single filer, no retirement plan participation:

* fully deductible

Joint filer, retirement plan participant with MAGI of:

* $89,000 or less — fully deductible
* $89,001–108,999 — partially deductible
* $109,000 or more — nondeductible

Joint filer, no retirement plan participation (but spouse is participant) with MAGI of:

* $167,000 or less — fully deductible
* $167,001–176,999 — partially deductible
* $177,000 or more — nondeductible

Married, filing separately with MAGI of:

* $0–$9,999 — partial contribution
* $10,000 or more — not eligible
None of the contribution is tax-deductible.
Tax credit for contributionsEligible taxpayers can claim a nonrefundable tax credit for contributions.

The maximum credit allowed is 50% of the annual contribution amount up to $2,000.

For 2009 and 2010, joint filers with a modified adjusted gross income (MAGI) of $55,500 or less and single filers with a MAGI of $27,750 or less qualify for the credit.
Same as traditional IRA.
Federal income-tax treatment on contributionsTaxes are deferred until distributions are made; taxable distributions are treated as ordinary income.

If nondeductible contributions have been made, each withdrawal is taxed proportionately.
Contributions are made with after-tax money; therefore, withdrawals from the contribution amount (basis amount) are always tax-free.
Federal income-tax treatment on earningsEarnings grow tax-deferred until distributions begin. Distributions are taxed as ordinary income.Qualified distributions are tax-free.

Nonqualified distributions: earnings are taxed as ordinary income.

Conversions: earnings are tax-free after the conversion amount satisfies the five-year investment period.
RolloversTo employer-sponsored plans: pretax contributions can be rolled over to a 401(k) or to another qualified plan, as well as to 403(b) and 457(b) plans. However, the receiving plan must accept IRA rollovers.

From employer-sponsored plans: eligible pretax and after-tax distributions from qualified plans, as well as from 403(b) and 457(b) plans, can be rolled over.
From/to another Roth IRA: allowed.

From employer-sponsored plans: eligible Roth contributions and earnings in 401(k) and 403(b) plans, can be rolled over.

In addition, non-Roth balances can be rolled over (see conversions for more info).
DistributionsDistributions from contributions and earnings can be taken after age 59-1/2 without federal tax penalty.

Mandatory withdrawals must begin at age 70-1/2.

Premature distributions are subject to a 10% penalty tax unless you qualify for the following exceptions:

* you’re age 59-1/2
* you’re disabled
* you’re taking substantially equal periodic payments
* the distribution is for certain medical bills
* the distribution is used for health insurance premiums during unemployment lasting at least 12 weeks
* the distribution is for post-secondary education expenses
* the distribution is used to purchase a first home (up to $10,000 lifetime maximum)

Distributions to your beneficiaries are also exempt from the 10% penalty.
Distributions from contributions can be made any time without taxes or federal tax penalty.

Distributions from earnings are tax-free if your initial contribution to the account was made at least five years ago and:

* you’re age 59-1/2
* you’re disabled
* you’re purchasing a first home

Payments made to your beneficiaries after the five-year period are also tax and penalty free. Payments made before the end of the five-year period are penalty free.

Distributions from earnings are not subject to the 10% penalty as long as you qualify for an exception:

* same as exceptions for traditional IRAs

Distributions from a conversion amount must satisfy a five-year investment period to avoid the 10% penalty. This pertains only to the conversion amount that was treated as income for tax purposes.
Required minimum distributions (RMDs)Must begin no later than April 1 of the year following the year the taxpayer turns 70-1/2. May be taken in a lump sum or annual payments. (Learn about the rules for RMDs.)

All IRA balances are aggregated, but the withdrawals may be taken from only one. However, the contributions/earnings are taxed pro rata.

Note: RMDs for tax year 2009 have been suspended.
No RMD applies before your death. After death, traditional IRA distribution rules apply for your beneficiaries.

Basic Roth IRA Rules

When it comes to the rules of the Roth IRA, the basic theme is: tax free money.  Who doesn’t like the idea of skimping the tax man later on in retirement.   While that general concept is simple, some of the rules can be confusing.

The easiest rule to comprehend are the contributions- what you put in is what you can take out at any time.  Since what you put into the Roth IRA is after tax and you get no tax deduction for putting money in, you will always have access to that money.  That’s why I’ve sometimes referred to the Roth IRA as a savings account on steroids.

General Roth IRA Posts

Roth IRA Rollover

Roth IRA Conversion