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, the late Senator William Roth of Delaware, a Roth IRA differs in several significant ways from other IRAs.

Overview

Established by the Taxpayer Relief Act of 1997 (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 is the lesser of your modified adjusted gross income (compensation) and the limit amounts 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
2008–2009*	$5,000	$6,000

For example, if you are single and earn $10,000, you can contribute a maximum of $5,000 in 2008. However, if you are single and earn $2,000, you can contribute only a maximum of $2,000 in 2008 ($2,000 is the lesser of $2,000 and $5,000).

*Starting in 2009, contribution limits will be assessed for a potential increase (in $500 increments) based on inflation, though the 2009 contribution limits have remained unchanged.

Differences from a traditional IRA

In contrast to a traditional IRA, contributions to a Roth IRA are not tax-deductible. Withdrawals are generally tax-free, but not always and not without certain stipulations (i.e., tax free when the account has been opened for at least 5 years for principal withdrawals and the owner's age is at least 59 ½ for withdrawals on the growth portion above principal). 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.

Advantages

Direct contributions to a Roth IRA may be withdrawn tax free at any time. Rollover, converted (before age 59½) contributions held in a Roth IRA may be withdrawn tax and penalty free after the "seasoning" period (currently 5 years). Earnings may be withdrawn tax and penalty free after the seasoning period if the condition of age 59½ (or other qualifying condition) is also met. This differs from a traditional IRA where all withdrawals are taxed as Ordinary Income, and a penalty applies for withdrawals before age 59½. In contrast, capital gains on stocks or other securities held in a regular taxable account for at least a year would be taxed at the lower long-term capital gain rate, which is currently 15%. This higher tax rate for withdrawals (and tax on the original contribution) from a traditional IRA is a quid pro quo for the deduction taken against ordinary income when putting money into the IRA.
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 without penalty, as long as the "seasoning" period (currently five years) has passed on the converted funds.
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 for a first time buyer. 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 deductible.)
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.
If the Roth IRA owner expects that the tax rate applicable to withdrawals from a traditional IRA in retirement will be higher than the tax rate applicable to the funds earned to make the Roth IRA contributions before retirement, then there may be a tax advantage to making contributions to a Roth IRA over a traditional IRA or similar vehicle while working. There is no current tax deduction, but money going into the Roth IRA is taxed at the taxpayer's current marginal tax rate, and will not be taxed at the expected higher future effective tax rate when it comes out of the Roth IRA.
Assets in the Roth IRA can be passed on to heirs, unlike Social Security.
The Roth IRA does not require distributions based on age. All other tax-deferred retirement plans, including the related Roth 401(k), require withdrawals to begin by April 1 of the calendar year after the owner reaches age 70½, If you don't need the money and want to leave it to your heirs, this is a great way to accumulate income tax free. Beneficiaries who inherited Roth IRAs are subject to the minimum distribution rules.
Since a Roth contribution has already been taxed, it may be 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 may be equivalent to a traditional IRA contribution of $6667 (assuming a 25% tax bracket at both contribution and withdrawal). In 2008 you cannot contribute $6667 to a traditional IRA due to the contribution limit, so the post-tax Roth contribution may be larger. However, many people end up in a lower tax bracket in retirement, or, the effective tax rate applicable to their traditional IRA withdrawals in retirement will be equal to or lower than their marginal tax rate while working, and they will not realize as much of this benefit. Regardless of whether marginal tax rates increase or decrease, Roth IRA earnings are not taxed, if you follow the rules.
On estates large enough to be subject to estate taxes, a Roth IRA can reduce estate taxes since tax dollars have already been subtracted. A traditional IRA is valued at the pre-tax level for estate tax purposes.

Disadvantages

Contributions to a Roth IRA are not tax deductible. By contrast, contributions to a traditional IRA are tax deductible (within income limits). Therefore, someone who contributes to a traditional IRA instead of a Roth IRA gets an immediate tax savings equal to the amount of the contribution multiplied by their marginal tax rate while someone who contributes to a Roth IRA does not realize this immediate tax reduction. Also, by contrast, contributions to most employer sponsored retirement plans (such as a 401(k), 403(b), SIMPLE IRA or SEP IRA) are tax deductible with no income limits because they reduce a taxpayer's adjusted gross income.
Eligibility to contribute to a Roth IRA phases out at certain income limits. By contrast, contributions to most tax deductible employer sponsored retirement plans have no income limit.
Contributions to a Roth IRA do not reduce a taxpayer's adjusted gross income (AGI). By contrast, contributions to a traditional IRA or most employer sponsored retirement plans reduce a taxpayer's AGI. One of the key benefits of reducing one's AGI (aside from the obvious benefit of reducing taxable income) is that a taxpayer who is close to the threshold income of qualifying for some tax credits or tax deductions may be able to reduce their AGI below the threshold at which he or she may become eligible to claim certain tax credits or tax deductions that may otherwise be phased out at the higher AGI had the taxpayer instead contributed to a Roth IRA. Likewise, the amount of those tax credits or tax deductions may be increased as the taxpayer slides down the phaseout scale. Examples include the child tax credit, or the earned income credit, or the student loan interest deduction.
A taxpayer who chooses to make a Roth IRA contribution (instead of a traditional IRA contribution or tax deductible retirement account contribution) while in a moderate or high tax bracket will likely pay more income taxes on the earnings used to make the Roth IRA contribution as compared to the income taxes that would have been due to be paid on the funds that would have been later withdrawn from the traditional IRA, had the taxpayer made a traditional IRA contribution. This is because contributions to traditional IRAs or employer sponsored tax deductible retirement plans result in an immediate tax savings equal to the taxpayer's current marginal tax bracket multiplied by the amount of the contribution. It has been shown that many people have a lower income in retirement than during their working years, and thus end up in a lower tax bracket in retirement, and this is another reason why withdrawals from a traditional IRA or tax deferred retirement plan in retirement are likely to result in a lower tax bill. The higher the taxpayer's marginal tax rate, the greater the disadvantage.
A taxpayer who pays state income taxes and who contributes to a Roth IRA (instead of a traditional IRA or a tax deductible employer sponsored retirement plan) will have to pay state income taxes on the amount contributed to the Roth IRA in the year the money is earned. However, if the taxpayer retires to a state with a lower income tax rate, or no income taxes, then the taxpayer will have given up the opportunity to avoid paying state income taxes altogether on the amount of the Roth IRA contribution by instead contributing to a traditional IRA or a tax deductible employer sponsored retirement plan, because when the contributions are withdrawn from the traditional IRA or tax deductible plan in retirement, the taxpayer will then be a resident of the low or no income tax state, and will have avoided paying the state income tax altogether as a result of moving to a different state before the income tax became due.
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.
Congress may change the rules that currently allow for tax free withdrawal of Roth IRA contributions. Therefore, someone who contributes to a traditional IRA is guaranteed to realize an immediate tax benefit, whereas someone who contributes to a Roth IRA must wait for a number of years before realizing the tax benefit, and that person assumes the risk that the rules will be changed during the interim.

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.

For Canadians with US Roth IRAs: A new rule (2008) provides that Roth IRAs (as defined in section 408A of the U.S. Internal Revenue Code) and similar plans are considered to be pensions. Accordingly, distributions from a Roth IRA (as well as other similar plans) to a resident of Canada will generally be exempt from Canadian tax to the extent that they would have been exempt from U.S. tax if paid to a resident of the U.S. Additionally, a resident of Canada may elect to defer any taxation in Canada with respect to income accrued in a Roth IRA but not distributed by the Roth IRA, until and to the extent that a distribution is made from the Roth IRA or any plan substituted therefor. The effect of these rules is that, in most cases, no portion of the Roth IRA will be subject to taxation in Canada.

However, where an individual makes a contribution to a Roth IRA while they are a resident of Canada (other than rollover contributions from another Roth IRA), the Roth IRA will lose its status as a "pension" for purposes of the Treaty with respect to the accretions from the time such contribution is made. Income accretions from such time will be subject to tax in Canada in the year of accrual. In effect, the Roth IRA will be bifurcated into a "frozen" pension that will continue to enjoy the benefit of the exemption for pensions and a non-pension (essentially a savings account) that will not.

Eligibility

Income limits

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 proportionally throughout the MAGI ranges shown below. Once MAGI hits the top of the range, no contribution is allowed at all, however a minimum of $200 may be contributed as long as MAGI is below the top of the range (e.g. A single 40 year old with MAGI $119,999 may still contribute $200 to a Roth IRA vs. $30). Excess Roth IRA contributions may be recharacterized into Traditional IRA contributions as long as the combined contributions do not exceed that tax year's limit. The Roth IRA MAGI phase out ranges for 2009 are:

Single filers: Up to $116,000 (to qualify for a full contribution); $116,000-$120,000 (to be eligible for a partial contribution)
Joint filers: Up to $169,000 (to qualify for a full contribution); $169,000-$176,000 (to be eligible for a partial contribution)
Married filing separately (if the couple lived together for any part of the year): $10,000

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.)

To be eligible, you must meet the earned income minimum requirement. In order to make a contribution, you must have taxable compensation (not taxable income from investments). If you make only $2000 in taxable compensation, your maximum IRA contribution is $2000.

Conversion limit

Currently only taxpayers with MAGI of less than $100,000 in the year of conversion and not married filing separately may convert from a traditional IRA to a Roth IRA (the converted amount is not included in MAGI). TIPRA 2005 eliminates the MAGI limit and filing status restriction 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.

Distributions

Direct contributions may be withdrawn at any time. Eligible (tax and penalty free) distributions of earnings must fulfill 2 requirements. First, the seasoning period of 5 years must have elapsed, and secondly a justification must exist such as retirement or disability. The simplest justification is reaching 59.5 years of age, at which point qualified withdrawals may be made in any amount on any schedule. In addition, one can retire earlier using the Substantially equal periodic payments rules. Also, becoming disabled or being a "first time" home buyer can provide justification for limited qualified withdrawals.

References

^ http://www.irs.gov/publications/p590/ch02.html#en_US_publink10006523
IRS Pub 590
See Final IRS Regulations, passed December 30, 2005 not exempting Roth 401k from mandatory distributions at age 70½
http://www.irs.gov/publications/p17/ch17.html#en_US_publink100033700

External links

IRS Publication 590 (IRAs) (pdf)
IRS ROTH IRA Publication 590 (HTML)
Roth IRA Conversions (pdf)
Foreign Tax non-deductible on IRA accounts

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