In an earlier post, we discussed the merits and mechanics of a traditional IRA. Today I want to talk about Roth IRAs, which are actually a better option for many taxpayers.
A Roth IRA is a retirement savings account that allows for investment earnings to grow on a tax-free basis, as long as distribution rules are followed. In other words, as long as you follow the rules, the earnings on your contributions will never be subject to tax. Sounds like a great deal, eh? It is, with a few qualifiers. One is that contributions are not deductible under any circumstances. With traditional IRAs, contributions are deductible subject to certain income limits. The money you contribute to a Roth IRA is already taxed as part of your income.
How much can be contributed to a Roth each year?
Another drawback to the Roth IRA is that there is a relatively low ceiling on the amount of funds that can be contributed on an annual basis. Taxpayers under age 50 can contribute up to $5,000 each year to a Roth IRA. Those over 50 can increase that amount by $1,000. If the taxpayer’s MAGI (modified adjusted gross income) is less than these limits, the contribution amount is capped at the level of the MAGI. For instance, if somebody earned $3,700 in 2010, they cannot exceed that $3,700 in IRA contributions. These limits apply to both traditional and Roth IRAs. You can contribute to both, but your total contributions cannot exceed these limits.
Who can contribute?
You cannot contribute to a Roth IRA at all if your income exceeds certain limits. For 2011, those limits are $122,000 as a single taxpayer, or $179,000 for married taxpayers filing jointly. And, to reiterate, you must have earned income in order to contribute to a Roth IRA. You can’t live off of fat dividend checks that are taxable at a lower rate than income, and then parlay those checks into unlimited tax-free income via a Roth.
When can I withdraw from a Roth IRA?
As a practical matter, you can always withdraw the contributions you've made to your Roth IRA without paying taxes or penalties, because you've already paid tax on those funds. You can also withdraw earnings from your Roth IRA if you are willing to pay taxes and possibly penalties. The penalty for taking a distribution that is not a "qualified distribution" is 10% of the amount withdrawn. That will come in addition to the taxes that must be paid on the earnings on your contributions. Obviously, that is undesirable. There are several factors to consider that might qualify a distribution, which frees you from all taxes and penalties.
First, the most basic criterion that qualifies a distribution is that it should be at least five years since your first Roth IRA contribution. Assuming that is the case, any of the following will qualify a distribution:
- you are at least 59 1/2 years old at the time of the distribution,
- the distribution is used to buy or rebuild a first home (subject to a maximum of $10,000),
- the distribution is necessary because you've become disabled, or
- the distribution is made to your beneficiary or estate in the event of your death.
There are several other exceptions and alternative distribution options that may be used to avoid paying penalties on distributions before age 59 1/2, but we'll save them for another post.
Are there other benefits to a Roth IRA?
Unlike other IRAs, there are no Required Minimum Distributions (RMDs) associated with a Roth IRA. This makes sense, because the IRS is not expecting any tax proceeds from Roth distributions, so there is no rush to ensure the funds are distributed. Furthermore, there are estate planning benefits associated with the Roth. Not only do you not have to take RMDs, which allows the money to grow tax-free for the duration of your life, the heirs who inherit your Roth will not have to pay income taxes when they withdraw the funds. Additionally, they can let the funds grow according to their life expectancy, which is generally more favorable than is the case with a traditional IRA.