A Roth IRA is an Individual Retirement Account (IRA) allowed under the tax law of the United States. Named for its chief legislative sponsor, Senator William Roth of Delaware, a Roth IRA differs in several significant ways from other IRAs.
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. 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 allowed per year 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):
|
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.
Differences from a traditional IRA
In contrast to a traditional IRA, contributions to a Roth IRA are not tax-deductible. Withdrawals are tax-free. An advantage of the Roth IRA over a traditional IRA is that there are fewer withdrawal restrictions and requirements. Transactions inside the Roth IRA account (including capital gains, dividends, and interest) do not incur a current tax liability. Withdrawals are generally tax free when the account has been opened for at least 5 years and the owner's age is at least 59 ½.
Advantages
- If there is money in the Roth IRA due to conversion from a Traditional IRA, the Roth IRA owner may withdraw up to the total of the converted amount, as long as the "seasoning" period (currently five years) has passed on the converted funds.
- Withdrawals of earnings are tax-free once the participant reaches age 59½ or becomes disabled, so long as the account is "seasoned" (established for five or more years).
- Direct contributions to a Roth IRA (i.e., not including rollovers) may be withdrawn at any time with no tax or penalty, since they have already been taxed.
- Up to $10,000 in earnings withdrawals are considered qualified (tax-free) if the money is used to acquire a principal residence. This house must be acquired by the Roth IRA owner, their spouse, or their lineal ancestors and descendants. The owner or qualified relative who receives such a distribution must not have owned a home in the previous 24 months.
- Contributions may be made to a Roth IRA even if the owner participates in a qualified retirement plan such as a 401(k). (Contributions may be made to a traditional IRA in this circumstance, but they may not be tax deductable.)
- If a Roth IRA owner dies, and his/her spouse becomes the sole beneficiary of that Roth IRA while also owning a separate Roth IRA, the spouse is permitted to combine the two Roth IRAs into a single account without penalty.[1]
- If the Roth IRA owner expects their tax bracket after retirement to be higher than before retirement, 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 Roth IRA is taxed at the lower current rate, and will not be taxed at the higher future rate when it comes out of the Roth IRA. If a taxpayer is currently in the 15% tax bracket, then a $1,000 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 for after retirement income as he received in tax benefits from the traditional IRA deduction. (Gains are compounded, so this comparison is valid.) Thus the Roth IRA offers a specific advantage where a person will retire in a higher tax bracket than that used during their pre-retirement years.
- The Roth IRA does not require distributions based on age. All other tax-deferred retirement plans, including the related Roth 401(k),[2] require withdrawals to begin by April 1 of the calendar year after the owner reaches age 70½, however, beneficiaries who inherited Roth IRAs are subject to the minimum distribution rules.
- Earnings in a Roth IRA are not taxed if withdrawn after the "seasoning" period and age 59½. Earnings in a Traditional IRA are taxed as Ordinary Income rather than capital gains even if the monies were invested in stocks or mutual funds, and a penalty applies for withdrawals before age 59½. In contrast, stocks or mutual funds held in a regular taxable account for at least a year would be taxed at the lower long-term capital gain rate, currently only 15%. This higher tax rate is a quid pro quo for the deduction taken against ordinary income when putting money into the IRA.
- Since a Roth contribution has already been taxed, it is equivalent to a larger contribution to a traditional IRA that will be taxed upon withdrawal. For example, a contribution of the 2008 limit of $5,000 to a Roth IRA is equivalent to a traditional IRA contribution of $6667 (assuming a 25% tax bracket at both contribution and withdrawal). However, in 2008 you cannot contribute $6667 to a traditional IRA due to the contribution limit, so the post-tax Roth contribution is actually larger.
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. The money in a traditional IRA is taxed once it is withdrawn at retirement.
- The contribution limit is phased out depending on income. (See below.)
- 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 one's 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 (To benefit from this exemption, the beneficiary must be named in the appropriate IRA beneficiary form. A beneficiary inheriting the IRA solely through a will will not be eligible for the estate tax exemption. Additionally, the beneficiary will be subject to income tax unless the inheritance is a Roth IRA). Although heirs will have to pay taxes on withdrawals from traditional IRA accounts they inherit, and must continue to take mandatory distributions (although it will be based on their life expectancy). It is also possible that tax laws may change by the time one reaches retirement age.
Double taxation
Double taxation still occurs within these tax sheltered investment accounts. For example, foreign dividends may be taxed at their point of origin, and the IRS does not recognize this tax as a creditable deduction. There is some controversy over whether this violates existing Joint Tax Treaties, such as the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital.
Eligibility
Income limits
As with 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 their 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)
- Married filing separately (if the couple lived together for any part of the year): $0 (to qualify for a full contribution); $0-$10,000 (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.)
The ranges for 2008 are:
- Single filers: Up to $101,000 (to qualify for a full contribution); $101,000-$116,000 (to be eligible for a partial contribution)
- Joint filers: Up to $159,000 (to qualify for a full contribution); $159,000-$169,000 (to be eligible for a partial contribution)
Conversion limit
Currently only taxpayers with MAGI of less than $100,000 in the year of conversion, regardless of tax filing status, may convert from a traditional IRA to a Roth IRA (the converted amount is not included in MAGI). TIPRA 2005 eliminates the MAGI limit on conversions starting in 2010. Thus regardless of income, contributions can be made to a traditional IRA in previous years, and then rolled over in 2010.
See also
- 401(k) IRA matrix – 401k & IRA comparisons (401k vs Roth 401k vs Traditional IRA vs Roth IRA)
References
External links
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