Common Questions about Roth IRA's

Roth IRA's have become a tremendously popular investment option for retirement, but what exactly is a Roth IRA? This article will tackle some common questions about the basics of Roth IRA's and clear up some of the confusion you may have.

What is a Roth IRA?

IRA stands for individual retirement account, and Roth IRA's are a specific type of IRA receiving different federal income tax treatment than other types of IRA's. The Roth has existed since the passage of the Taxpayer Relief Act of 1997 which was then modified by the Technical Corrections Act of 1998 to include section 408(a) “Establishment of Nondeductible Tax-Free Individual Retirement Accounts”.¹ Senator William Roth of Delaware was the sponsor of this legislation, so that is how this type of IRA got its name.

The attractiveness of the Roth IRA is its federal income tax treatment. You pay taxes on the money contributed to the Roth in the year you make the contribution. The tax code allows the money to grow tax free in the account, so you do not have to pay income tax on the money earned by the Roth, and if you take money out for any of the specific “qualified distributions” listed in the tax code, then you will not have to pay any income tax then either. Since tax rates tend to increase rather than decrease over time, it is seen as beneficial to pay taxes on the contributions up front. However, there is always the possibility that Congress will change the laws and make withdrawals taxable.

How does a Roth IRA work?

You make a contribution of money by depositing it into your Roth account. The money can then be used to buy shares of mutual funds or be placed in other types of investments such as Certificates of Deposit. Discuss with your financial advisor what type of investment and investing strategy are right for you.

So how does this money grow? The invested money earns interest, has capital gains or losses, and/or is paid dividends, depending on what kind of asset the money is invested in. The earnings of the account are kept in the account and reinvested, allowing the account to grow even more, and over a period of years, this compounding really adds up to big bucks. When you retire and begin to withdraw money from your Roth IRA, the interest, gains, and dividends are completely tax-free if you comply with the qualified distribution rules.

What is a contribution to a Roth IRA?

A contribution must be made in cash and comply with income and timing requirements. You must have had earned income in the year you make the contribution. Earned income includes wages, salaries, tips, professional fees, bonuses, commissions, self-employment income, and taxable alimony. For example, in 2007 if you earn $2000 from working at your job and you also receive $25 in interest from a savings account, you may only contribute $2000, not $2025. There are also income limits as determined by your filing status and what your Modified Adjusted Gross Income (MAGI) is on your federal tax return.²

2007 Roth IRA Contribution Phase-Out and Elimination

If your filing status is married filing jointly or qualifying widow(er), and your modified AGI is at least $156,000, your contribution limit begins to phase-out. When your AGI reaches or exceeds $166,000 you cannot make a Roth IRA contribution at all.

If your filing status is married filing separately and you lived with your spouse at any time during the year, your phase-out begins when your modified AGI is more than -0-. You cannot make a Roth contribution if your modified AGI is $10,000 or more.

For all other filing statuses the phase-out begins when your modified AGI reaches $99,000, and you cannot make a Roth IRA contribution when your modified AGI equals or exceeds $114,000.

Contributions can be made for the current year during the current year. The only exception is that contributions for a certain year are permissible until April 15 of the following year. For example, you may make a 2007 Roth IRA contribution until April 15, 2008. If April 15 happens to fall on a weekend or holiday, the deadline is extended to the next working day after April 15. This cut-off date for contributions coincides with the due date for your federal tax return.

Are there any limitations to making a contribution to a Roth IRA?

Besides the earned income requirement and income phase-out limitations discussed above, another limitation is the amount of money you are allowed to deposit in your Roth. For 2007, if you are 49 years of age or younger, you can contribute up to $4000 in 2007 and $5000 in 2008. If you are over 49 years of age, you may contribute up to $5000 in 2007 and $6000 in 2008.³

What is a conversion and a rollover?

Conversions occur when you choose to transform all or part of your traditional IRA into a Roth. The main reason you may choose conversion is to take advantage of the tax treatment that the Roth IRA provides by having tax-free withdrawals. The rules for conversion can be quite complex, so you'll need to talk to your financial advisor to learn the specifics of your situation, and you may owe income tax on the money converted.

Rollovers occur when you receive a distribution from a traditional IRA. You have 60 days to contribute it, or roll it over, into a Roth. Other retirement accounts like 401(k)'s, 403(b)'s, and SIMPLE IRA's can be indirectly converted into a Roth IRA using the rollover method. First, these funds must be rolled over into a traditional IRA, and then the traditional IRA may be converted into a Roth IRA.

One important note is that Roth IRA's cannot be converted into Traditional IRA's.

How do you maintain a Roth IRA?

You are not required to make contributions to your Roth IRA. Once you start a Roth with one initial deposit, you are not required to make any other deposits, so there are really no maintenance requirements. However, the Roth IRA won't grow as much without contributing to it regularly, so it is advisable to make contributions whenever possible. Also, there are generally fees charged by the custodian of your Roth IRA, so check with your financial institution about yearly maintenance fees.

How does a Roth IRA affect my federal income tax?

Unfortunately, there are no tax benefits in the year you make a contribution to a Roth. If you contribute $3000 in 2007, you cannot deduct that $3000 from your income on your federal tax return. However, the big tax payoff comes when you begin to receive distributions from your Roth. If the distribution is “qualified” by meeting certain requirements, then you will pay no tax at all on the money you take out of your Roth IRA.

What is a qualified distribution?

A qualified distribution is any withdrawal of money from your Roth IRA which will be tax free. There are four types of qualified distributions:

1. You held the Roth IRA for five years, and you reach age 59½
2. You held the Roth IRA for five years, and you become disabled
3. You held the Roth IRA for five years, and you die and the withdrawal is made to a beneficiary of the Roth IRA or to your estate
4. You held the Roth IRA for five years, and you are a qualified first time home buyer ($10,000 limit).

In these four circumstances, you will not have to pay any federal income tax on the money withdrawn from your Roth.

Can I withdraw money in any circumstance other than the ones in the previous answer?

Yes, you can withdraw money from your Roth IRA at any time; however, if the distribution is not one of the four qualified distribution types listed above, you will be subject to a 10% tax penalty. But, as usual, there are even some exceptions to the 10% penalty rule. You will not have to pay the 10% penalty in the following circumstances:

1. The distributions are part of a series of substantially equal payments.
2. You have significant unreimbursed medical expenses.
3. You are paying medical insurance premiums after losing your job.
4. The distributions are not more than your qualified higher education expenses.
5. The distribution is due to an IRS levy of the qualified plan.
6. The distribution is a qualified reservist distribution.⁴

Can I start a Roth IRA if I already participate in another retirement plan, such as my company's pension plan or profit sharing plan like 401(k)?

Yes, you may participate in other retirement plans and still start a Roth IRA. The only consideration you must keep in mind is that if you have both Traditional and Roth IRA's, you cannot contribute more than $4000 combined to both of them in 2007. This means that you cannot contribute $4000 to your traditional IRA and another $4000 to the Roth IRA. You can contribute $2000 to the traditional and $2000 to the Roth, or split it up however you want, as long as the total does not exceed $4000.

Do I have to stop making contributions after reaching a certain age?

No, you can make contributions at any age as long as you have earned income and comply with the income limitations and timing requirements, discussed above.

Do I have to withdraw money at a certain age?

No, you never have to withdraw any money from your Roth IRA if you choose not to. You may keep all of the money in the Roth IRA and leave to your beneficiaries who may then have use of the account.

What happens to my Roth IRA after I die?

You may designate primary and secondary beneficiaries who will inherit your Roth IRA after your death. A primary beneficiary is the person who will receive the Roth IRA after your death, usually a spouse or children. In the event that your primary beneficiary dies before you do, you can name a contingent beneficiary who will inherit the Roth IRA if the primary beneficiary is deceased.

We've covered common questions investors typically have when starting to learn about Roth IRA's. This article does not cover all aspects of the Roth, but you can use these questions and answers as a starting point for considering Roth IRA's as one of your retirement planning options. Talk with your financial advisor to determine if Roth IRA's are right for your personal goals and situation.