Like the Traditional IRA, a Roth IRA (established by the Taxpayer Relief Act of 1997) is a common way for individuals to save for their retirement. The Roth IRA's main difference from the Traditional IRA is that, rather than granting a tax break for money placed into the plan, the tax break is granted on the money withdrawn from the plan during retirement. The Roth IRA offers tax-free growth and tax-free withdrawals in retirement. It can be established as either an individual retirement account or an individual retirement annuity and must be designated as a Roth IRA when it is opened.
Are you eligible to open a Roth IRA or continue to invest is an existing one?
First, you need to have “earned” income. This is income you make from working, typically in the form of salary, hourly wages, profit from a small business, or self-employment. Other income that is also included is taxable alimony and military differential pay. Some types of income that do not qualify are interest and dividends from investments, pension payments, and income from rental property.
Second, there are income limits the federal government has in place that will determine if you are eligible to contribute to a Roth IRA. The amount you can contribute is “phased out” (www.irs.gov) at certain levels of income, which means your contribution limit may be reduced if your modified adjusted gross income is above a certain level. The level where the reduction occurs is adjusted each year for inflation, and depends on your filing status.
2015 Roth Income And Annual Contribution Limits
*If you are age 50 or above, an additional $1,000 "catch-up" contributions is allowed for the year 2015.
If your earned income exceeds the income limits, you may still be able to effectively contribute by using a "backdoor" contribution process (www.investopia.com). You can contribute to a Traditional IRA and then convert that account to a Roth IRA (as of 2015 you can perform one IRA conversion per year).
If your earned income is less than your eligible contribution amount, your maximum contribution amount equals your income. In other words, if you have $4,000 in earned income, the most you can contribute to the Roth is $4,000 (instead of $5,500 or $6,500 if you are eligible for a “catch-up” contribution).
A Roth IRA can be established at any time at any age. Contributions for a tax year must be made by the owner’s tax-filing deadline, which is generally April 15th of the following year. You can contribute to a Roth even if you participate in a retirement plan through your employer.
Spousal Roth IRA Contributions
An individual may establish and fund a Roth IRA on behalf of his or her spouse who makes little or no income. Spousal Roth IRA contributions are subject to the same rules and limits as that of regular Roth IRA contributions and must be held separately from the Roth IRA of the individual making the contribution. Roth IRAs cannot be held as joint accounts. The couple must be married and file a joint tax return.
Distribution Rules
An investor can withdraw contributions to a Roth IRA any time without tax or penalty. This is not the case for any earnings or interest that you have earned on your Roth IRA investment. In order for a distribution to be qualified (the earnings are not taxable or subject to a 10% early withdrawal penalty), the following must occur:
- The Roth IRA holder is at least age 59.5 when the distribution occurs.
- Your initial contributions must be in the Roth IRA for at least five years regardless of the age you opened it. The clock starts on January 1st of the year you make your first contribution. There is not a new 5-year clock for each Roth IRA contribution or for each Roth IRA that is held. This is not the case with a Roth IRA conversion. The 5-year rule clock restarts with every conversion and each conversion amount has its own 5-year time period. So, with multiple conversions, there may be multiple 5-year periods in progress.
Distribution Exceptions
You may not have to pay the 10% early withdrawal penalty in the following situations:
- You use the money to pay for a first time-home ($10,000 lifetime limit).
- The distribution is made to a beneficiary or to your estate after you die.
- You become disabled.
- Medical expenses exceeding 10% of your adjusted gross income.
- You are paying medical insurance premiums after losing your job.
- The distributions are not more than your qualified higher education expenses (for yourself or eligible family members).
Minimum distributions
Unlike with a Traditional IRA, the Roth IRA is not subject to the Required Minimum Distribution rules during the lifetime of the owner. You cannot use your Roth IRA to satisfy minimum distribution requirements for your Traditional IRA (you generally have to start taking withdrawals from your Traditional IRA after you reach age 70.5).
Distributions to beneficiaries
You can pass your Roth IRA on to your beneficiaries, and their withdrawals will be tax-free. If the sole beneficiary is the spouse, he or she can treat your Roth IRA as their own and will not have any required distribution requirements.
For non-spouse beneficiaries, Roth IRAs are subject to Required Minimum Distribution rules after the death of the owner with a 50% penalty if such distributions are not made. Generally, the entire interest in the Roth IRA must be distributed by the end of the fifth calendar year after the year of the owner's death unless the interest is payable to a designated beneficiary over the life or life expectancy of the designated beneficiary.
Carol Chaudet