What is a Roth IRA
The Roth IRA was created in the Taxpayer Relief Act of 1997. Named after the late United States Senator William V. Roth, Jr. (R-DE), the Roth IRA has four features that differ significantly from a traditional IRA. First, contributions are not tax-deductible in the year in which they are made. Second, distributions that are paid out after age 59 ½ are tax-exempt provided certain requirements are meant. Third, as long as an account owner has earned income, he or she can contribute to a Roth IRA, even if older than 70 ½. Fourth, distributions are not mandatory, even after the account reaches age 70 ½.
Like a traditional IRA, the contribution limit for 2011 is $5,000 for those who are younger than 50 and $6,000 for those who are 50 or older. However, not everyone can contribute to a Roth IRA. In order to establish a Roth IRA for 2011, a person whose tax filing status is single, head of household, or married and filing separately (and did not live with his or her spouse at any point during the year) must have a modified adjusted gross income of $120,000 or less. A person whose filing status is married and filing jointly, must have a modified adjusted gross income of $177,000 or less. Finally, those whose status is married and filing separately (and did live with a spouse at any point during the year), must have a modified adjusted gross income of $10,000 or less.
Regardless of the amount of modified adjusted gross income, anyone wishing to establish a Roth IRA must have earned compensation. Just as with a traditional IRA, earned compensation is defined as money that is earned from working, such as wages, salaries, tips, commissions, self-employment income, alimony and separate maintenance payments, and nontaxable combat pay. Compensation is not defined as earnings or profits from the rental or sale of property, income from interest, dividends, pensions or annuities, compensation that has been deferred from a previous year, or income earned from a foreign source.
Where to Invest a Roth IRA
Just like a traditional IRA, a Roth IRA can be opened with any qualified custodian. It's common for those in their 20s and 30s to keep IRA accounts at a brokerage firm. This allows the account holder to trade stocks and exchange-traded funds in order to accumulate a substantial amount of money before shifting to a more conservative asset allocation in later years.
Older investors should also make sure that they have stocks and other financial instruments that allow for growth. But they may be more comfortable keeping their accounts with mutual funds companies that allow for more diversified investing.
Converting to a Roth IRA
Much has been made over the past several years about converting a traditional IRA to a Roth IRA. While this can make sense for some, it usually doesn't make financial sense to do so. When you convert a traditional IRA to a Roth IRA, you must declare the amount you're converting as income. For example, if you want to convert an IRA worth $50,000 and you earn $75,000 that year, your taxable income will be $125,000. That's because the taxes on the traditional IRA were deferred. Now that the distribution is being made, taxes are due.
If you're nearing retirement and you know that you'll be in a specific tax bracket based on traditional IRA distribution, profit sharing, pension, and social security income, you may not want to convert the traditional IRA if that bracket is lower than the one you're currently in. If, however, you have 20 or more years before retirement, it may make sense to do the conversion. A Roth IRA is always worth more than a traditional IRA, even if the account values are the same. This is because a Roth IRA is funded with after-tax dollars. The earnings on both types of accounts aren't taxed, but the distributions from the Roth are tax-exempt. So, if each account is worth $50,000, the Roth account is actually worth $50,000. The traditional IRA is worth $50,000 less the taxes that have been deferred.
While no one can predict what will happen in the future, especially when it comes to income and taxes, it's always best to discuss a Roth conversion with a financial planner or tax advisor. The gains of converting the account may outweigh the taxes due, or they may not.
Roth IRA Distributions
In general, there are two requirements for a qualified distribution: The distribution is made 5 years after the first taxable year the contribution was made and the account owner has reached age 59 ½. If neither of these qualifications is met, the distribution is subject to a 10% penalty.
Under certain circumstances, distributions that are made before the 5-year period or before the account owner reaches age 59 ½ might not be assessed the 10% penalty. For example, if the account owner becomes permanently disabled, if he or she is the non-spouse beneficiary of a deceased account owner, if he or she uses the distribution for the purchase of a first house, if there are substantial un-reimbursed medical expenses, if the distributions are used to pay medical insurance premiums following the loss of a job, the distribution is the result of an IRS levy issued against the plan, or it is a qualified distribution to a reservist. If you are considering taking an early distribution from a Roth IRA, it's always best to discuss the implications with a financial planner or tax specialist prior to proceeding.
Distributions that meet the Age 59 ½ Rule and the 5 Year Rule are paid to the account owner tax-free. This is one reason why Roth IRAs have become so popular over the past several years. Retirement savers who previously contributed to traditional IRAs are realizing that while it's good that their accounts have grown significantly, the taxes that have been deferred for 20, 30, or more years will eventually have to be paid. Since the amount of the distribution is based on the total value of all of the traditional IRA accounts that are owned and the life expectancy of the account owner, the marginal tax rate can be the same as it was during his or her working years. Traditional IRAs are funded and sold on the assumption that the tax rate for most people will be lower after retirement. However, this is not always true.
While we've covered the basics of IRA investing here, there is much more to maximizing the success of you IRA. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
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