The Roth IRA
There have been a lot of questions about the Roth IRA. The following will answer your questions if you qualify and also help you make a decision between a traditional IRA and a Roth IRA.
Who qualifies for a Roth IRA
If you are single or head of household, and your adjusted gross income is $95,000 a year or less, you qualify. If you are married and file jointly and your adjusted gross income is $150,000 or less, you also qualify for the full $2000 annual contribution. If you are married and file separately, do not even bother to read on. You can participate in the Roth IRA whether you are participating in another retirement plan or not. Your non-working spouse can also participate in a Roth IRA.
With both the traditional and Roth IRAs, you can start tapping into your nest egg at age 59 ½. If you choose not to wait, the penalty is 10%.
The traditional IRA makes you start making withdrawals after you reach the age of 70 ½. This does not apply to the Roth IRA. You can leave your money in the Roth IRA until you die if you wish. You can contribute up to $2000 and, in most cases your spouse can do the same. If you are both 40 and work until 65, this would mean you will be able to put $100,000 in a Roth IRA. Assuming 10% annual appreciation, that would give you $430,000 when you retire. Every penny will be tax-free.
Traditional or Roth IRA
Traditional IRAs give you deductions each year for your annual contributions. When you take the money out, all distributions, including any interest, dividends and capital gains are taxed as ordinary income.
The Roth IRA, however, works the other way around. You pay taxes now with the Roth IRA. Your Roth contributions are not tax-deductible, but all distributions are tax-free, provided you hold the Roth IRA for at least 5 years and reach the age of 59 ½. You can withdraw from a Roth IRA to offset non-deductible medical expenses, college, insurance premiums not paid by your employer or your first home without having to pay the 10% penalty. The homebuyer can be you, your spouse, your kids, grandchildren or even your parents as long as the buyer or his spouse has not owned a primary residence for the past two years. You can withdraw your non-deductible contributions from the Roth IRA, plus up to $10,000 in the plan’s earnings, to help buy the home.
Rolling over to a Roth IRA
Congress has come up with a way that permits you to rollover your traditional IRA to a Roth IRA. There is a tax to pay of course. The rules can also be a bit tricky. You can convert existing IRAs to Roth IRAs if your adjusted gross income is less than $100,000 a year, not counting the amount you plan to transfer.
You will be required to pay ordinary income taxes on the entire amount you roll over. If you have to use your IRA contributions to pay the taxes, this is not a good idea.
You can also partially roll over to a Roth IRA. If you choose to do this, it is very important to finish the job. It is a tax and financial nightmare if you reach the age 70 ½ and you need to start taking distributions from your traditional IRAs and some of the money was rolled into a Roth IRA.
You have until April 15th to start a new Roth IRA. If you plan to leave your IRA to an heir, talk with a financial professional to know what will happen to that IRA when you die. Make sure the heir understands the rules also.
If your income is around the cutoff limit stated above, wait until you are sure that you will qualify before you open a Roth IRA. Run the numbers or have your CPA help you before you make a move. You need to look at best and worse case scenarios. If your tax bracket is high now and you believe it will be lower at your retirement age, you may want to pick the traditional IRA. If your tax bracket is 15% now, go with a Roth IRA. Hopefully you will have a higher income at retirement and be in a higher tax bracket. If your income is too high now for a Roth IRA, you can always open a nondeductible IRA and then convert it in a year when your income falls below the limit.