Top 10 Roth IRA Questions
Q. I intend to retire at 50. When I do, I'll need income. Can I take money from my Roth IRA without paying any taxes or penalties?
A. Potentially, yes. Under the IRS ordering rules, you are allowed to remove your original contributions at any time without tax or penalty. In addition, after you've waited at least five tax years, you're able to withdraw your original converted amounts without taxes or penalties. It's only when you get to the earnings generated by the original contributions and conversions that you will have a tax and/or penalty problem.Even if you do determine that you'll have to break into the earnings before you reach age 59 1/2, you may still be able to avoid the penalty -- but not necessarily the tax. If you remove the funds from your Roth IRA account using a distribution method that is part of a scheduled series of substantially equal periodic payments made over your life expectancy (and the life expectancy of your beneficiary), you may still be penalty-free.
Q. When I convert my regular IRA to a Roth IRA, do I have to pay the taxes all at once?
A. Yes. You're required to report the entire conversion income in the year of conversion. There was a one-time option to spread out conversion income when Roth IRAs first came out in 1998, but that option is no longer available.
Q. If I convert my IRA to a Roth IRA, will that income increase my adjusted gross income for the current year?
A. Absolutely. The income you have to report for an IRA conversion to a Roth IRA will have an impact on all tax issues that are based on AGI -- except for any direct Roth contribution and/or conversion issues. In other words, if you meet the AGI limitation rules to convert or contribute to a Roth before taking the conversion income into consideration, this income won't make you ineligible based on an increased AGI. But any tax provisions that use AGI as a guidepost will be affected -- including medical expenses (7.5% AGI floor), miscellaneous deductions (2% AGI floor), taxability of Social Security (based on AGI), passive loss limitations (based on AGI), and many others.In some cases, your AGI may be severely affected. You must take that into consideration when you decide to make a Roth IRA conversion.
Q. If I have a large tax balance due next April because of my Roth IRA conversion, will I be able to avoid the underpayment penalties related to estimated taxes?
A. No. You can't be exempted from the underpayment penalty just because the balance due was caused by a Roth IRA conversion. There are other exceptions to the underpayment penalty that you might want to review, since they may allow you to dodge the penalty, but there is no "safe harbor" simply because the underpayment was caused by a Roth IRA conversion.
Q. I've heard from a friend that the AGI limitation for a Roth IRA is $100,000. I've heard from other friends that the actual AGI limitation is much higher. Which is it?
A. It depends on whether you're talking about a conversion or a contribution.If you're talking about converting your regular IRA to a Roth IRA, then the AGI limitation is $100,000 for all filing categories, except for married folks filing separately. They're effectively prohibited from making a conversion no matter how small their AGI is, unless the couple is separated and has lived apart for the entire tax year.But, if you're talking about making a contribution to a Roth IRA, then the rules are a bit different. The AGI limitations depend on your filing status. If you're single and your 2007 modified AGI is less than $116,000 (or married with modified AGI of less than $166,000), you'll be eligible for at least a partial Roth IRA contribution.
Friday, November 14, 2008
Top 10 Roth IRA Questions Part -1
Top 10 Roth IRA Questions
Even though the Roth IRA has been around for more than 10 years, people still have a lot of questions about how it works. Today, I'll review 10 frequent questions about the Roth, with the hope of helping you better understand this valuable IRA option.
Q. Can my 16-year-old make a Roth IRA contribution?
A. As long as your child has earned income with which to open the Roth IRA account, and as long as he or she falls under the adjusted-gross-income (AGI) limitations, then he or she can make an IRA contribution regardless of age. The key is having earned income, such as from working a job. See more on this point a few questions down.
Q. Can my 73-year-old parent convert a regular IRA to a Roth IRA?
A. Again, age is not a determining factor. If your parent's AGI is less than the $100,000 limitation, then your parent is eligible to make the conversion. Any required minimum distributions that your parent must take from a regular IRA will not count against the $100,000 AGI limitation.
Q. I'm retired and drawing Social Security. Can I contribute part of my Social Security benefits to a Roth IRA account?
A. Nope. Sorry. To make a Roth IRA contribution, you must have earned income. Earned income is generally money you receive as compensation for your labor. It's reported to you on a W-2 form, or you report it on Schedule C (Business Income) or Schedule F (Farm Income) with your normal tax return. Earned income typically does not include Social Security benefits, pensions, interest, dividends, rental income, or capital gains. It can, however, include alimony.
Q. I want to contribute to my Roth IRA, but my custodian says I can't put annual contributions into an account that has been converted. Is this true? And if so, what should I do?
A. There's no legal reason for you to separate your contribution and conversion funds into separate accounts. Under the old Roth IRA rules, contributions and conversions had different five-tax-year start times, depending on conversion and/or contribution dates. Because of these staggered start times, the IRS suggested that contributions and conversions be maintained in separate Roth IRA accounts. That suggestion was then passed on to financial institutions, and the institutions passed that information on to their clients.But with the changes that the Tax Reform Act of 1998 brought to the Roth IRA, the need for these separate accounts has been negated. It is now acceptable to commingle your Roth IRA conversions and contributions. While there are still staggered start times for contributions versus conversions, the rules surrounding those start times are much clearer. So having conversions and contributions in the same account, though still tricky, isn't impossible to deal with.
If your broker still insists that you separate your conversion funds and contribution funds, make sure to tell him or her of the new law that removed the segregation restrictions. And if that doesn't work, consider finding a new broker.
Q. I converted my regular IRA to a Roth IRA back in January. I've just discovered that my AGI will exceed the $100,000 conversion limitation this year. What should I do?
A. You can "recharacterize" your converted Roth IRA back to a traditional IRA without any penalty or tax. You just need to do it before Oct. 15 of the following year. That's right -- the following year. If you made your conversion in January 2007, the recharacterization wouldn't have to take place until Oct. 15, 2008. You're also required to "unconvert" not only your original conversion amount, but also any of the earnings generated by that original conversion.
So, just because you go over the AGI limitation, that doesn't mean all is lost. Your broker should be able to help you recharacterize back to a regular IRA account.
Even though the Roth IRA has been around for more than 10 years, people still have a lot of questions about how it works. Today, I'll review 10 frequent questions about the Roth, with the hope of helping you better understand this valuable IRA option.
Q. Can my 16-year-old make a Roth IRA contribution?
A. As long as your child has earned income with which to open the Roth IRA account, and as long as he or she falls under the adjusted-gross-income (AGI) limitations, then he or she can make an IRA contribution regardless of age. The key is having earned income, such as from working a job. See more on this point a few questions down.
Q. Can my 73-year-old parent convert a regular IRA to a Roth IRA?
A. Again, age is not a determining factor. If your parent's AGI is less than the $100,000 limitation, then your parent is eligible to make the conversion. Any required minimum distributions that your parent must take from a regular IRA will not count against the $100,000 AGI limitation.
Q. I'm retired and drawing Social Security. Can I contribute part of my Social Security benefits to a Roth IRA account?
A. Nope. Sorry. To make a Roth IRA contribution, you must have earned income. Earned income is generally money you receive as compensation for your labor. It's reported to you on a W-2 form, or you report it on Schedule C (Business Income) or Schedule F (Farm Income) with your normal tax return. Earned income typically does not include Social Security benefits, pensions, interest, dividends, rental income, or capital gains. It can, however, include alimony.
Q. I want to contribute to my Roth IRA, but my custodian says I can't put annual contributions into an account that has been converted. Is this true? And if so, what should I do?
A. There's no legal reason for you to separate your contribution and conversion funds into separate accounts. Under the old Roth IRA rules, contributions and conversions had different five-tax-year start times, depending on conversion and/or contribution dates. Because of these staggered start times, the IRS suggested that contributions and conversions be maintained in separate Roth IRA accounts. That suggestion was then passed on to financial institutions, and the institutions passed that information on to their clients.But with the changes that the Tax Reform Act of 1998 brought to the Roth IRA, the need for these separate accounts has been negated. It is now acceptable to commingle your Roth IRA conversions and contributions. While there are still staggered start times for contributions versus conversions, the rules surrounding those start times are much clearer. So having conversions and contributions in the same account, though still tricky, isn't impossible to deal with.
If your broker still insists that you separate your conversion funds and contribution funds, make sure to tell him or her of the new law that removed the segregation restrictions. And if that doesn't work, consider finding a new broker.
Q. I converted my regular IRA to a Roth IRA back in January. I've just discovered that my AGI will exceed the $100,000 conversion limitation this year. What should I do?
A. You can "recharacterize" your converted Roth IRA back to a traditional IRA without any penalty or tax. You just need to do it before Oct. 15 of the following year. That's right -- the following year. If you made your conversion in January 2007, the recharacterization wouldn't have to take place until Oct. 15, 2008. You're also required to "unconvert" not only your original conversion amount, but also any of the earnings generated by that original conversion.
So, just because you go over the AGI limitation, that doesn't mean all is lost. Your broker should be able to help you recharacterize back to a regular IRA account.
Opening and Funding a Roth IRA Account
Opening and Funding a Roth IRA Account
You can open a Roth account at any time. Whether you can contribute to it for any given tax year depends on your income and filing status: see the rules page.
The choice of who to open your account with depends on your choice of what type of investments you want in it. If you want to invest in individual stocks or ETFs, you'll open your account with the stockbroker of your choice (preferably a low-cost one). If you want to invest in index funds or other mutual funds, you'll open your account with the fund provider. In each case, you'll specify that the account is a Roth IRA account, rather than a regularly-taxed account, at the time you open it.
If You're Just Starting Out ...
If you're just starting to save for retirement and are overwhelmed by all the choices, you can start with something very simple now - you can always modify your portfolio years from now when you are more experienced and knowledgeable. The obvious starting investment for your account would be a Total Stock Market ("TSM") index investment (either a regular index fund or an ETF). Two equally easy ways to go:
Choose a low-fee TSM from a respected, well-known index fund provider that has a customer-friendly reputation. (Ideally they will have a wide selection of other low-fee index funds, so that you can modify your portfolio several years from now when you may want to.) You can open an account on their website, specifying that it's a Roth IRA account rather than a regular account.
- or -
Choose a low-fee TSM ETF, again from a classy provider. This time you open your account with your choice of stockbrokers, again specifying that it will be a Roth IRA account. Once the account is open you'll buy shares of the ETF using its symbol.
More Generally ...
Generally speaking, your Roth account is appropriate for the least tax-efficient funds in your long-term retirement portfolio. Let's make that more clear by taking a specific example. Suppose you have decided to build a retirement portfolio out of three types of index investments: total stock market, foreign, and small value.
Portfolio turnover (that's the percent of the fund's stock portfolio that gets sold and reinvested every year) and dividends are the causes of tax inefficiency; so based on these numbers, the small value fund is the logical choice for the Roth IRA account; the other two would do fine in a regularly taxed account.
You can open a Roth account at any time. Whether you can contribute to it for any given tax year depends on your income and filing status: see the rules page.
The choice of who to open your account with depends on your choice of what type of investments you want in it. If you want to invest in individual stocks or ETFs, you'll open your account with the stockbroker of your choice (preferably a low-cost one). If you want to invest in index funds or other mutual funds, you'll open your account with the fund provider. In each case, you'll specify that the account is a Roth IRA account, rather than a regularly-taxed account, at the time you open it.
If You're Just Starting Out ...
If you're just starting to save for retirement and are overwhelmed by all the choices, you can start with something very simple now - you can always modify your portfolio years from now when you are more experienced and knowledgeable. The obvious starting investment for your account would be a Total Stock Market ("TSM") index investment (either a regular index fund or an ETF). Two equally easy ways to go:
Choose a low-fee TSM from a respected, well-known index fund provider that has a customer-friendly reputation. (Ideally they will have a wide selection of other low-fee index funds, so that you can modify your portfolio several years from now when you may want to.) You can open an account on their website, specifying that it's a Roth IRA account rather than a regular account.
- or -
Choose a low-fee TSM ETF, again from a classy provider. This time you open your account with your choice of stockbrokers, again specifying that it will be a Roth IRA account. Once the account is open you'll buy shares of the ETF using its symbol.
More Generally ...
Generally speaking, your Roth account is appropriate for the least tax-efficient funds in your long-term retirement portfolio. Let's make that more clear by taking a specific example. Suppose you have decided to build a retirement portfolio out of three types of index investments: total stock market, foreign, and small value.
Portfolio turnover (that's the percent of the fund's stock portfolio that gets sold and reinvested every year) and dividends are the causes of tax inefficiency; so based on these numbers, the small value fund is the logical choice for the Roth IRA account; the other two would do fine in a regularly taxed account.
Roth IRA Contribution Limits
Roth IRA Contribution Limits
IRAs were created to encourage people to save for their retirement, by offering them a significant tax break. They are intended for ordinary working people - not, for example, the wealthy (income limits prevent them from participating), or trust fund kids too lazy to get a job (contributions have to be made from salary, not from investments or other income).
The rules for eligibility and contribution limits change every year. You can (and should) get the official rules from IRS Publication 590;
To summarize how all of the rules work:
If your status is Married Filing Separately you are effectively locked out due to an extremely restrictive limit. (The rationale: the government doesn't want to give you a tax break in case your spouse is high-income. The exception: if you and your spouse lived apart for the whole year, you get the same limits [and same bummer lifestyle] as a Single filer.)
If your status is anything else, then your contribution limit is (using 2008 numbers):
$5000 if your income is low enough (and $6000 if you're 50 or older)
zero (that is, you can't contribute at all) if your income is too high
a sliding scale somewhere in between, if your income is somewhere in between "low enough" and "too high"
In case you have multiple IRAs, the limit is the total you are allowed to contribute to all of them
And in all cases, your total contributions can't be greater than your reported salary income.
If you don't qualify...
If your income is too high to make a Roth IRA contribution, you may still be eligible for a traditional deductible IRA if neither you nor your spouse is covered by a retirement plan at work. See IRS Publication 590. (Look under "Traditional IRAs".)
Penalties
A Roth IRA is intended to be a retirement account, so penalties apply if you misuse it by withdrawing funds too early. As a rule, you should plan not to make any withdrawals until at least age 59½ or five years after you make your first contribution, whichever comes later. This rule does have exceptions: see IRS Publication 590 for details. (Search for "Qualified Distributions".)
IRAs were created to encourage people to save for their retirement, by offering them a significant tax break. They are intended for ordinary working people - not, for example, the wealthy (income limits prevent them from participating), or trust fund kids too lazy to get a job (contributions have to be made from salary, not from investments or other income).
The rules for eligibility and contribution limits change every year. You can (and should) get the official rules from IRS Publication 590;
To summarize how all of the rules work:
If your status is Married Filing Separately you are effectively locked out due to an extremely restrictive limit. (The rationale: the government doesn't want to give you a tax break in case your spouse is high-income. The exception: if you and your spouse lived apart for the whole year, you get the same limits [and same bummer lifestyle] as a Single filer.)
If your status is anything else, then your contribution limit is (using 2008 numbers):
$5000 if your income is low enough (and $6000 if you're 50 or older)
zero (that is, you can't contribute at all) if your income is too high
a sliding scale somewhere in between, if your income is somewhere in between "low enough" and "too high"
In case you have multiple IRAs, the limit is the total you are allowed to contribute to all of them
And in all cases, your total contributions can't be greater than your reported salary income.
If you don't qualify...
If your income is too high to make a Roth IRA contribution, you may still be eligible for a traditional deductible IRA if neither you nor your spouse is covered by a retirement plan at work. See IRS Publication 590. (Look under "Traditional IRAs".)
Penalties
A Roth IRA is intended to be a retirement account, so penalties apply if you misuse it by withdrawing funds too early. As a rule, you should plan not to make any withdrawals until at least age 59½ or five years after you make your first contribution, whichever comes later. This rule does have exceptions: see IRS Publication 590 for details. (Search for "Qualified Distributions".)
Understanding Roth IRA
A Roth IRA is an Individual Retirement Account that provides tax-free growth. As a result, it's the simplest - and potentially the most effective - sheltered account imaginable.
The Roth Tax AdvantageTax Structure of a Roth IRA-->
Like a deductible IRA, Roth gives you the advantage of getting taxed only once, rather than twice (or more) as with a regularly-taxed investment account. Here is a summary of how it works:
Regularly-Taxed Account
You pay income tax, and then make your contribution with post-tax dollars
Your principal may be subject to taxes on dividends and capital gains as it grows
You pay capital gains tax on your gain at withdrawal
Deductible IRA
You get a tax deduction, essentially letting you deposit pre-tax dollars
Your principal grows tax-free
You pay income tax on the entire amount of your withdrawal
Roth IRA
You pay income tax, and then make your contribution with post-tax dollars
Your principal grows tax-free
You pay no further taxes on withdrawal.
The advantage of a Roth IRA over a regularly-taxed account is obvious. Either way you pay income tax up front. But with Roth, you're then done paying taxes; with a regular account you're just getting started.
The advantage of a Roth IRA over a deductible IRA is almost obvious:
Roth is simple: it requires no special reporting to the IRS. (With a deductible IRA you have to report a deduction on your 1040 form when you make a contribution; on withdrawal you report the entire withdrawal amount as taxable income.)
Roth is flexible: because you've taken care of your tax obligations up front you tend to face fewer restrictions later. (For example, you don't need to begin withdrawing your money by a set age; with a deductible IRA you're required to start making withdrawals by age 70½.)
Roth has an extra advantage if you think taxes will probably rise in the future, since you're paying now rather than later. (Of course that's a disadvantage if you think taxes will fall.)
Roth has an additional, somewhat confusing advantage that it lets you shelter more real money: the same dollar amount, but in post-tax, rather than pre-tax dollars. (The idea is that a tax deduction isn't "money you're getting back"; it's "money you aren't sheltering".) This issue is analyzed, in more detail than you probably want to see
Friday, October 24, 2008
How to Open a Roth IRA Account
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. It is one of the smartest investments for young people. Your money grows absolutely tax free and it's more flexible than a 401(k). You can take money out for emergencies. You can use the money to buy your first home. You can use the money to save for your childrens' educations.
STEPS
Prioritize your investments. A Roth IRA is generally a better investment than a 401(k) because you won't pay taxes on the withdrawals; however, if your employer is making matching contributions, take advantage of that first, then open the Roth IRA.
Decide if you want your Roth IRA invested in stocks, bonds, mutual funds, CDs, or real estate.
Choose stocks if you are young. A discount broker can set that up for you.
Sharebuilder.com for example
Enter your social security number and the social security numbers of your beneficiaries.
Choose a price point program. The least expensive is $4.00 per month per stock.
Decide if you are saving for a car, a house, a college education, or retirement.
Discover what kind of investor you are. The portfolio builder will then ask a series of questions designed to classify you as a conservative, balanced, moderate or aggressive investor.
Review a list of suggested investments. These will either be index funds (similar to mutual funds) or individual stocks (Apple, Google, Exxon, etc).
Choose mutual funds if you have little experience investing. A fund company can set that up for you. Sometimes you can start with as little as $1000, and sometime you can set it all up online.
Choose CDs for the lowest risk. A bank can set that up for you.
Find the money. You might have to save it up, invest your tax refund or sign up for automatic withdrawls from your checking account.
TIPS
In a traditional IRA, you make contributions based on pre-taxed dollars, but you receive heavy penalties if you withdraw money from the account before you turn 59 1/2. A Roth IRA allows you to withdraw the money without worrying about penalties, but the money that you contribute to the account is done with taxed dollars.
If a 25-year-old contributes $4,000 each year until she retires and makes an average annual return of 8% on her investment, she'll have more than $1.1 million saved by the time she is 65.
If a 15-year old contributes $2,000 a year until she is 18 and makes an average annual return of 9% on her investment, She'll have more than $370,000 saved by the time she is 60.
If a 15-year old contributes $2,000 a year until she is 60 and makes an average annual return of 9% on her investment, She'll have more than $1.2 million saved by the time she is 60.
WARNINGS
You can contribute to a Roth only if you have taxable income from a job.
You cannot save more than you earn.
In 2007, you could contribute $4,000 per year if income falls below $99,000 (single) or $156,000 (married filing jointly). In 2008, you can contribute $5,000 per year. If you are 56 years old, you can contribute $6,000 per year.
STEPS
Prioritize your investments. A Roth IRA is generally a better investment than a 401(k) because you won't pay taxes on the withdrawals; however, if your employer is making matching contributions, take advantage of that first, then open the Roth IRA.
Decide if you want your Roth IRA invested in stocks, bonds, mutual funds, CDs, or real estate.
Choose stocks if you are young. A discount broker can set that up for you.
Sharebuilder.com for example
Enter your social security number and the social security numbers of your beneficiaries.
Choose a price point program. The least expensive is $4.00 per month per stock.
Decide if you are saving for a car, a house, a college education, or retirement.
Discover what kind of investor you are. The portfolio builder will then ask a series of questions designed to classify you as a conservative, balanced, moderate or aggressive investor.
Review a list of suggested investments. These will either be index funds (similar to mutual funds) or individual stocks (Apple, Google, Exxon, etc).
Choose mutual funds if you have little experience investing. A fund company can set that up for you. Sometimes you can start with as little as $1000, and sometime you can set it all up online.
Choose CDs for the lowest risk. A bank can set that up for you.
Find the money. You might have to save it up, invest your tax refund or sign up for automatic withdrawls from your checking account.
TIPS
In a traditional IRA, you make contributions based on pre-taxed dollars, but you receive heavy penalties if you withdraw money from the account before you turn 59 1/2. A Roth IRA allows you to withdraw the money without worrying about penalties, but the money that you contribute to the account is done with taxed dollars.
If a 25-year-old contributes $4,000 each year until she retires and makes an average annual return of 8% on her investment, she'll have more than $1.1 million saved by the time she is 65.
If a 15-year old contributes $2,000 a year until she is 18 and makes an average annual return of 9% on her investment, She'll have more than $370,000 saved by the time she is 60.
If a 15-year old contributes $2,000 a year until she is 60 and makes an average annual return of 9% on her investment, She'll have more than $1.2 million saved by the time she is 60.
WARNINGS
You can contribute to a Roth only if you have taxable income from a job.
You cannot save more than you earn.
In 2007, you could contribute $4,000 per year if income falls below $99,000 (single) or $156,000 (married filing jointly). In 2008, you can contribute $5,000 per year. If you are 56 years old, you can contribute $6,000 per year.
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