Many
people have questions about the benefits of a Roth IRA. No deduction is available for contributions
made to a Roth IRA, but you may be entitled to a credit (saver's credit) against
tax for your contribution. In addition,
the earnings on the contributed amounts build up tax-free and it's fairly easy
to qualify for tax-free distributions for retirement.
Contributions. You can contribute up to $4,000 a year to
a Roth IRA (as long as you have compensation for the year at least equal to the
contributed amount). This limit is $5,000 a year for people who will be age 50
(or older) during the year. However, the $4,000 maximum contribution allowance
is reduced by any contributions (deductible or nondeductible) you make to
“regular” IRAs. For 2006 through 2007, the limit is $4,000, and after 2007, the
limit is $5,000. After 2008, the $5,000 limit will be increased when the
cost-of-living index warrants it. Individuals age 50 or older can make
additional contributions of $1,000 in 2006 and in following years.
Unfortunately,
there are some limits on Roth IRA contributions. For single taxpayers, if
adjusted gross income (AGI) is $110,000 or more, no contribution can be made to
a Roth IRA. If AGI is between $95,000 and $110,000, the $4,000 maximum
contribution is phased out (reduced) according to a formula. For married
taxpayers filing jointly, no contribution can be made if AGI is $160,000 or
more, and the $4,000 maximum (per spouse) is phased out for AGIs
between $150,000 and $160,000. For married taxpayers filing separately, the
allowable contribution is phased out for AGIs between
$0 and $10,000.
You
may be allowed a credit against your income tax equal to a percentage of your
Roth IRA contribution if your AGI doesn't exceed certain levels (which are much
lower than the phase-out AGI levels above). Contributions can be made to Roth
IRAs even if you are a participant in a qualified plan
and even if you reach age 70-1/2.
Distributions. “Qualified” distributions from a Roth IRA
are tax-free. Thus, you can avoid tax on Roth IRA earnings forever (i.e., even
at distribution). A distribution is qualified if made: once you reach age
59-1/2, upon death or disability, or (up to $10,000 per lifetime) for
first-time homebuyer expenses. However, a distribution is not qualified if made
within the five-year period beginning with the first tax year you made a
contribution to a Roth IRA.
A
nonqualified distribution is treated first as a nontaxable return of
contributions. To the extent a nonqualified distribution exceeds contributions
it is taxable and is also subject to a 10% penalty under the regular early
withdrawal rules (i.e., the penalty will not apply if the distribution is made
once you reach age 59-1/2, or upon death or disability, or in other limited
circumstances).
Qualified rollover contributions. You may be able to roll funds over from a
regular IRA into a Roth IRA so the post-rollover income can grow tax-free in
the Roth IRA. (Converting a regular IRA into a Roth IRA is treated as such a
rollover.) You can roll funds over from a regular IRA to a Roth IRA only if your AGI, calculated with specified modifications, does not
exceed $100,000 in the rollover year. Any funds rolled over will be taxed under
the regular IRA distribution rules as if there were no rollover. The 10% early
withdrawal penalty will not apply to the rollover. However, if rolled over
funds are withdrawn within the five year period that renders them taxable, the
10% penalty will apply to the withdrawal. Beginning in 2010, the $100,000 AGI
ceiling on conversions from a traditional IRA to a Roth IRA will be removed.
Ordering
rules apply if a Roth IRA contains conversion amounts (possibly from different
years) as well as other contributions. The regular Roth IRA contributions are
treated as withdrawn first and then converted amounts, starting with amounts
first converted. Withdrawals of converted amounts will be treated as coming first
from amounts already included in income. Earnings are treated as withdrawn
after contributions. For these purposes, all Roth IRAs will be treated as a
single Roth IRA.
Certain
elements of the Roth IRA can be complicated. Nonetheless, many taxpayers can
benefit significantly from Roth IRAs. Please give our firm a call if you would
like to discuss these matters further.