Roth IRA

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A Roth IRA is an individual retirement account (IRA) allowed under the tax law of the United States. Named for its chief legislative sponsor, U.S. Senator William V. Roth, Jr. of Delaware, a Roth IRA differs in several significant ways from other IRAs.

1 Overview
2 Differences from a traditional IRA
- 2.1 Advantages
- 2.2 Disadvantages
3 Eligibility: Income limits
- 3.1 Conversion Limit
4 External links

[edit] Overview

Established in 1998 (Public Law 105-34), A Roth IRA can invest in securities, usually common stocks or mutual funds (although other investments, including derivatives, notes, certificates of deposit, and real estate are possible.) As with all IRAs, there are specific eligibility and filing status requirements mandated by the Internal Revenue Service. A Roth IRA's main advantage is its tax structure. Contributions are made only from earned income that has already been taxed (and is not tax deductible), but withdrawals up to the total of contributions are federal income tax free, and withdrawals of earnings (anything above the total of contributions) are often free of federal income tax. Depending on with whom a Roth IRA is set up, it can be managed in creative ways, including investments in non-typical assets (Self-Directed IRA).

The total contributions to all IRAs are limited as seen below (this total may be split up between any number of Traditional and Roth IRAs. In the case of a married couple, each spouse may contribute the amount listed):

Year	Age 49 and Below	Age 50 and Above
1998–2001	$2,000	$2,000
2002–2004	$3,000	$3,500
2005	$4,000	$4,500
2006–2007	$4,000	$5,000
2008*	$5,000	$6,000

*Starting in 2009, contribution limits will increase in $500 increments based on inflation.

[edit] Differences from a traditional IRA

In contrast to a Roth IRA, contributions to a traditional IRA may be tax deductible if certain eligibility requirements are met, but withdrawals are included in the account owner's income (and thus subject to income tax). Another advantage of the Roth IRA over a traditional IRA is that there are fewer restrictions and requirements on withdrawals. With both types of IRA, transactions inside the account (including capital gains, dividends, and interest) incur no tax liability. Here is a 401(k) versus IRA matrix that compares various types of IRAs with various types of 401(k)s.

[edit] Advantages

At any time, the IRA owner may withdraw up to the total of his contributions (in nominal dollars).

If there is money in the IRA due to conversion from a Traditional IRA, the IRA owner may withdraw up to the total of the converted amount, as long as the "seasoning" period has passed on the converted funds (currently, five years).

Withdrawals of more than the total of contributions + seasoned conversions are considered withdrawals of earnings, and are subject to tax and penalty if they are not qualified.

Earnings withdrawals become automatically qualified in the tax year the participant reaches age 59.5 or becomes disabled, so long as the account is "seasoned" (established for five or more years).

Up to $10,000 in earnings withdrawals are considered qualified if the money is used to acquire a principal residence. This house must be acquired by the IRA owner, their spouse, or their lineal ancestors and descendants. The owner or qualified relative who receives the "first time homeowner" distribution must not have owned a home in the previous 24 months.

If a Roth IRA owner dies, and their spouse becomes the sole beneficiary of their Roth IRA while that spouse also owns a separate IRA, the spouse is permitted to combine the two Roth IRAs into a single account without penalty. Additionally, qualified distributions are also available to other beneficiaries of Roth IRA owners. See IRS Pub 590 for complete details.

If the Roth owner expects his/her tax bracket during retirement to be higher than presently, there is a tax advantage to making contributions to a Roth IRA over a Traditional IRA or similar vehicle. There is no current tax deduction, but money going into the IRA is taxed at the lower current rate, and will not be taxed at the higher future rate when it comes out of the IRA. If a taxpayer is currently in the 15% tax bracket, then a $1000 contribution to a traditional IRA would provide a $150 reduction in current-year tax liability. If that taxpayer were in the 30% tax bracket upon retirement, $1000 of traditional IRA distributions would incur $300 in taxes. Therefore, the person would pay twice as much on retirement income as he or she received in tax benefits from the traditional IRA deduction (and since gains are compounded, this comparison is valid). Therefore, the Roth IRA offers a specific advantage where a person will retire in a higher tax bracket than that used during his or her pre-retirement years.

Perhaps the greatest advantage of the Roth IRA is its lack of forced distributions based on age. All other tax-deferred retirement plans, including the Roth IRA's cousin, the Roth 401(k)*, require withdrawals to begin at age 70½ (more precisely, by April 1 of the calendar year after age 70½ is reached), and impose an annual minimum distribution once withdrawals begin at any age beyond 59½. The Roth IRA is completely free of these mandates.

See Final IRS Regulations, passed December 30, 2005 not exempting Roth 401k from mandatory distributions at age 70.5.

[edit] Disadvantages

The main disadvantage of a Roth IRA (when compared to a traditional IRA) is that contributions are not tax-deductible. If one contributes $1000 to a traditional IRA while in a high tax bracket, one can often receive a tax deduction, substantially reducing the initial cost of contributing (or, potentially, allowing someone without much disposable income to shelter more income). This is not the case for the Roth IRA. It should be noted that the money in a traditional IRA is taxed once it is withdrawn at retirement. If one is not able to max out one's IRA contributions, and ends up in a lower income tax bracket at retirement, then one will wind up with less usable cash by choosing a Roth IRA over a Traditional IRA.

With a Roth IRA, there are heavy penalties for early withdrawals of earnings (withdrawals up to the total of contributions + conversions are tax-free). An unqualified withdrawal of earnings will result in federal income tax plus a ten-percent penalty on the amount. Fortunately there are many exceptions, such as buying a first home and paying qualified educational expenses.

There is also the risk that Congress over the next few decades may decide to tax earnings on Roth IRAs.

The perceived tax benefit may never be realized, i.e., one might not live to retirement or much beyond, in which case, the tax structure of a Roth only serves to reduce an estate that may not have been subject to tax. One must live until their Roth IRA contributions have been withdrawn and exhausted to fully realize the tax benefit. Whereas, with a traditional IRA, tax might never be collected at all, i.e., if one dies prior to retirement with an estate below the tax threshold, or goes into retirement with income below the tax threshold.

[edit] Eligibility: Income limits

Like many tools that offer tax advantages, Congress has limited who can contribute to a Roth IRA, based upon income. A taxpayer can only contribute the maximum amount listed at the top of the page if his or her Modified Adjusted Gross Income (MAGI) is below a certain level (the bottom of the range shown below). Otherwise, a phase-out of allowed contributions runs throughout the MAGI ranges shown below. Once MAGI hits the top of the range, no contribution is allowed at all. The ranges, for 2007, are:

Single filers: Up to $99,000 (to qualify for a full contribution); $99,000-$114,000 (to be eligible for a partial contribution)
Joint filers: Up to $156,000 (to qualify for a full contribution); $156,000-$166,000 (to be eligible for a partial contribution)

The lower number represents the point at which the taxpayer is no longer allowed to contribute the maximum yearly contribution. The upper number is the point as of which the taxpayer is no longer allowed to contribute at all. Note that people who are married and living together, but who file separately, are only allowed to contribute a relatively small amount.

However, once a Roth IRA is established, the balance in the account remains tax-sheltered, even if the taxpayer's income rises above the threshold. (The thresholds are just for annual eligibility to contribute, not for eligibility to maintain an account.)

[edit] Conversion Limit

TIPRA 2005 eliminates the MAGI limit on rollovers from a traditional IRA to a Roth IRA. Thus regardless of income, contributions can be made to a traditional IRA in previous years, and then rolled over in 2010.