All about the Roth IRA – your key to tax-free retirement!

If you’ve read my primer on retirement, you should have a good idea of the benefits of investing in a Roth IRA. If you haven’t read it, let me give you a quick rundown before we get into the gritty details:

Meet the Roth IRA

Unlike a Traditional IRA (“Individual Retirement Account”), with a Roth IRA you have to pay taxes on the income that you invest. (The money you put into a Roth IRA is called a “contribution.”) However, instead of that money (plus all the growth) being taxed when you take it out at retirement (after age 59 1/2), with a Roth IRA you get to make the withdrawal tax-free (The money that you take out of a Roth is called a “distribution.”)

Also, like a Traditional IRA or 401k, all the growth and reinvested dividends in a Roth IRA grow tax-free while they remain in the Roth account.

That’s the Roth IRA in a nutshell. Now let’s look at some of the details below that might also sway your decision on where to put your retirement money. (And for a complete look at those details, you can check out IRS publication 590. I’ll warn you though, it’s as dry as the name suggests.)

The Roth IRA has “rules and $#%&” too…


In order to contribute money to a Roth IRA, you must have “earned income” that amounts to at least as much you’re going to invest. Thus, if you want to put in $2500 into your Roth IRA in 2010, you must’ve received at least that amount of earned income in the same year. This then begs the question, “what the heck counts as earned income?”

Earned income (or “compensation”) is defined as wages, salaries, tips or professional fees. Essentially, it’s what shows up on your W-2 as “wages, salary, tips” etc. This does NOT include money from investments like interest, dividends, or capital gains. Also NOT included as compensation are payments from social security, disability, pensions, annuities or income from property.

The most you can contribute in one year to a Roth IRA is $5,000 for 2010 (that is, if you ONLY contribute to a Roth IRA for retirement.) This amount will be adjusted in $500 increments, when required, to keep pace with inflation. There is one exception to this maximum IRS limit: if you’re 50 years old or older prior to 2011, you can contribute an additional “catch up” amount of $1,000 to your Roth IRA, for a grand total of $6,000 in 2010.

In 2010, in order to contribute to a Roth IRA, you also must have an Adjusted Gross Income (AGI) of less than $121,000 if you’re filing single ($177,000 for those married filing jointly.)  Also, the amount you can contribute to a Roth IRA is “phased out” for those filing single whose AGI is between $106,000 ($167,000 if filing jointly) and $121,000 ($177,000 filing jointly.)

One nice thing about the contributions to a Roth IRA is that for a given year (say, 2010), you have until the tax deadline in the following year to make contributions. Therefore, for most people, April 15th 2011 would be the last day you could make Roth IRA contributions for 2010.

(Special note on employer-matching contributions for Roth 401ks: Employer-sponsored Roth 401ks are similar in their tax treatment to Roth IRAs (and similar in their contribution limits to ‘regular’ 401ks, which are pre-tax.  One important difference is that employer matching contributions are ALWAYS pre-tax, and will go into regular 401k accounts, even if your own contributions are sent to a Roth 401k.)


If the idea of receiving tax-free income in your golden years isn’t enough, the Roth IRA also has some other benefits when it comes to receiving distributions.  These benefits give you some flexibility and liquidity that is usually reserved for taxable accounts.

Distribution of your regular contributions – You can take out the amount you’ve contributed to a Roth IRA tax- & penalty-free at anytime (I recommend only doing this if you really have to; chant the mantra: “Retirement savings are for retirement!”) For example, let’s say you’ve contributed $5000 per year for 4 years to your Roth IRA. Then, at age 42, you lose your job and need to tap your IRA in this emergency situation. You could take up to $20,000 worth of distributions from your Roth IRA without penalty tax-free, since you made an equal amount of contributions over the years.

Qualified Distributions – With a Traditional IRA, you can generally only take the money out without penalty if you’re over 59 1/2, and then you still have to pay normal income tax on that money. With a Roth IRA, some of the ways in which you can take out money tax and penalty-free are known as “qualified distributions.”

“A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.

  1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
  2. The payment or distribution is:
    1. Made on or after the date you reach age 59½,
    2. Made because you are disabled,
    3. Made to a beneficiary or to your estate after your death, or
    4. One that meets the requirements listed under First home under Exceptions in chapter 1 [of IRS publication 590] (up to a $10,000 lifetime limit).”

If you receive a distribution that is not a qualified distribution, you may have to pay the 10% additional tax on early distributions.

Item D means that if you’re a first-time home-buyer, you can take a distribution of up to $10,000 in earnings (after using all the contributions) for the purchase of this home (as part of a down-payment, for example.) If your spouse has a Roth IRA and is also a first-time home-buyer, she could use $10,000 of her Roth IRA in the home purchase as well (for a total of $20,000 between the two of you.) Note that you can also use your Roth IRA distributions in the same way for a child, grandchild, parent or other ancestor that is a first-time home-buyer.

Additionally, should you kick the bucket early, your beneficiaries can use your Roth IRA distributions tax-free. This makes a nice life insurance bonus out of the Roth IRA (for your sake, a benefit that hopefully won’t be used!)

You can also use Roth IRA distributions penalty-free (but not tax-free) for up to the amount required to pay for your qualified higher-education expenses (as long as you paid for those expenses with savings, loans, wages, a gift or an inheritance, and NOT through a tax-free scholarship or grant.)  Even though your Roth earnings withdrawals are not tax-free for qualified higher education expenses, you may be able to used tuition deductions or education credits to offset the taxes from that income.  (However, there are much better ways to save for eduction.)

“Qualified higher education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board are qualified higher education expenses.”

This means that if you want to start a retirement fund but think that in several years you might decide to buy a house (for the first time) or go back to school, a Roth IRA may be a good place for your money in any event.  However, I would caution that if your plan is to use a Roth IRA to fund something other than your retirement, you can’t really count that Roth IRA money as part of your future retirement.

As stated in my article on retirement, I believe that funds set aside for retirement should ONLY be used for that purpose. So, make sure you keep your “true” retirement money separated (at least in your mind) from your “maybe-for-school-or-a-house, maybe-for-retirement” money.

Conversion – You can also convert a Traditional IRA or 401k/403b into a Roth IRA. Keep in mind that you’ll have to pay the taxes in the current year at ordinary income rates on the basis amount of Traditional IRA that you’re converting.  So, if you’re in the 25% tax bracket and convert a $100K Traditional IRA to a Roth, you’ll pay $25K in taxes that year.  (For 2010 conversions ONLY, you have the option of spreading the $100K of income equally over 2011 and 2012.)

Avoid the 10% penalty on withdrawals of Roth funds from converted IRAs

One important exception to the general rule of being allowed to take contributions out of Roth IRAs at any time tax & penalty-free is converted IRAs.  If you convert a Traditional IRA/401k to a Roth IRA, you cannot take out any money within the 5 tax-year period starting with the year that the conversion was made unless you want to pay the 10% penalty (bad idea.)  So, if you convert in tax year 2010, you can’t withdraw those rollover contributions until January 1st, 2015.

Ready, set, Roth!

Now you should have a deeper understanding of the Roth IRA, a powerful retirement vehicle that could save you a bundle in taxes after you retire. If you combine the over-59 1/2 tax-free distributions with the additional distribution flexibility of funding your first home purchase or higher-education costs with your Roth, this IRA might be the right investment vehicle for you.

(To find out why the Roth IRA may NOT be the best retirement vehicle for you, read this.)

Author: Ward Williams

Ward is an independent financial advisor at Better Tomorrow Financial. He started working as an independent investment advisor in 2009.

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