What is a Roth IRA and Who Needs One?

Roth IRA

The Roth IRA is a great retirement savings tool that has many features and benefits.  Let’s explore some of the basics and reasons why a Roth IRA might be right for you or someone in your household.

What is a Roth IRA?

A Roth IRA is an individual retirement plan where the contributions are made after taxes are paid on the income. Many different types of accounts and investments can be designated as a Roth IRA: Savings account, CD, mutual fund, stock portfolio, and even investment real estate.

What are the features of a Roth IRA?

  • Taxes:  Contributions are not tax deductible. Earnings and withdrawals are tax-free.  This allows for amazing compound growth and no tax worries at retirement time when you withdraw the funds – and tax rates may be higher or you are in a higher tax bracket.
  • Contribution limits: Same annual limits as the Traditional IRA.  In 2012, the annual limit to any combination of Traditional or Roth IRA per worker is $5,000.  If you are 50 or over, you get an extra $1,000 as a Catch-up Contribution – bringing your total to $6,000 per year.
  • Age: There is no age limit.

Who is allowed to contribute to a Roth IRA?

Anyone who has taxable compensation, as long as the household income does not exceed certain amounts (see below).  You must earn at least the amount of your contribution.  The exception is a Spousal IRA which allows an underemployed or stay-at-home spouse to contribute up to the limit.

Who works and is NOT allowed to contribute the maximum to a Roth IRA?

There is an income ceiling with a phase-out range based on your Modified Adjusted Gross Income (MAGI).  Review IRS Publication 590 for more details.

  • Married filing jointly or qualifying widow: Maximum contribution up to $173,000 phasing out to $182,999.  No contributions allowed if income is $183,000 and above.
  • Single, head of household, or married filing separating and you did not live with your spouse during the year: Maximum contribution up to $110,000 phasing out to $124,999.  No contributions allowed if income is $125,000 and above.
  • Married filing separately and you lived with your spouse anytime during the year and actively participating in an employer’s retirement plan: Phased out between $0 and $10,000.  No contribution allowed if income is $10,000 and above.

What are other benefits of a Roth IRA?

  • Contribution withdrawals: Contributions can be withdrawn without any penalties at any time. But keep in mind that the withdrawal can never be put back! Your intent should be to use these funds for retirement – even though they can be easily withdrawn for other reasons.
  • Earnings withdrawals: Earnings can be withdrawn without any penalties or taxes if open for more than 5 years and used for specific reasons: a first time homebuyer (up to $10,000), higher education expenses, you become disabled, have extreme medical expenses, for medical insurance after receiving unemployment for 12 weeks, and a few others. Consult a tax professional for the current IRS policies on qualified withdrawals.
  • No Required Minimum Distribution: No Required Minimum Distribution beginning at age 70 ½.  If market conditions are poor and the funds aren’t needed, you can wait until the value rises again.
  • Withdrawals may begin at age 59 without any worries about penalties on earnings or taxes.

Who benefits the most from a Roth IRA?

  • Starting-out & rising-income workers: The worker who is just starting out, works in a low-paying field, or is still in the rising-income phase benefits the most.  Taxes paid on the contributions are estimated to be lower in rate and bracket compared to the peak of the career and at retirement time when the funds are withdrawn.
  • Workers who have been unemployed and getting back to work: The Saver’s Credit gives a tax credit when a lower-income worker over the age of 18 contributes to either type of IRA.  If you’ve been out of work or underemployed for part of the year, the contribution to a Roth IRA has more punch with a lower tax rate on the contribution and the credit!
  • Saver’s Credit details: Check out IRS Publication 8880 to calculate the tax credit available ranging from 10-50% of the contribution total.  The credit is not available once a single person earns more than $28,250, a head of household person earns $42,375, and a married filing jointly person earns more than $56,500. Keep in mind that dependents, a full-time student for at least 5 months of the year, and a few other types of workers are not eligible for the Saver’s Credit. More details available from the IRS.
  • Stay at home or part-time employed spouse: A Roth IRA is a wonderful retirement tool for the spouse who works part-time or stays at home.  During these years, the household income might be in a low tax bracket while a spouse goes to school, works part-time, or stays home to raise children.
  • Working teens: Teens have the dual benefit of a very low tax bracket and decades of compound earnings when saving for retirement. In addition to the monetary benefits, contributing to a retirement plan from the first paycheck establishes good saving habits.  Parents may offer to match a teen’s contribution to start the process.
  • Beneficiaries: A spouse can roll the balance into their own Roth IRA and avoid any Required Minimum Distributions as the account continues to grow tax-free.  A child or grandchild can elect to receive tax-free distributions over their lifetime tax-free while the balance continues to grow tax-free. Always consult a tax professional if you have any questions about naming beneficiaries or inheriting a Roth IRA.

Roth 401K and Roth TSP plans

Many of the Roth IRA features are now available with your workplace 401K plans and coming soon to the government’s Thrift Savings Plan.  Ask your employer today about the option of a Roth 401K or Roth TSP.  The main difference between these accounts and the Roth IRA is that any match is treated as a pre-tax contribution.

Is the Roth right for you?

The Roth IRA is just one of several tools that may be available to you and your spouse for saving for the retirement.  By understanding the features, benefits, and limits of the different types of IRAs and employer retirement plans, you can mix and match according to your specific situation.

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11 Comments
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  1. Is anyone else worried that a future congress will impose a tax on Roth IRA accounts? As the bankruptcy of the nation becomes harder to ignore they will look to new sources of “revenue”…

    • Joe – There has been speculation of changes of the Roth benefits in the future. However, the contributions have been taxed already – so those withdrawals will remain tax free.

      Any tax-free earnings are estimated to be grandfathered in should this take place. Finally, eliminating the tax-free growth will certainly end much of the participation in the Roth IRA.

      As society continues to stress more savings from it’s population and less reliance on government retirement benefits, I hope that Congress does not tap into the Roth IRA as a solution for revenue.

  2. I don’t forsee them imposing a tax on existing accounts, but will they impose a tax on future contributions? Very likely.

    I make too much to put into a Roth, so I contribute to a non-deductible IRA and converted it to a Roth…congress began allowing this in 2010 and until they act, we can continue to convert to a Roth.

    • Many employer retirement plans now allow a Roth contribution that is not subject to income limits.

      Government employees and active duty military will have the option of a Roth Thrift Savings Plan within the next few months.

  3. “As society continues to stress more savings from it’s population and less reliance on government retirement benefits, I hope that Congress does not tap into the Roth IRA as a solution for revenue” — Honestly, it seems like whatever people do, the government finds a way to get money from them. State pension plans are in trouble, social security is in trouble… they dip into our retirement all the time, so I see no reason why they won’t also try to tap into the Roths too.

    • The only thing certain is death and taxes – so I believe we need to build our household savings and personal retirement funds with one eye on the present and one eye on the future.

      No one can predict anything about the market & taxes, but we have to do our best with the knowledge we have right now.

      During difficult market times, we personally had to tell ourselves that at least we are saving for our future, we are living on less than we make, and we know how to downsize & conserve when needed. All good things – regardless of tax treatments and market rates of returns.

  4. Cherie,

    I think the other commenters are all hitting the read issue on the head. It isn’t whether one will make more now (Trad) or in retirement (Roth) but whether the government will keep its promise 30 years from now. That is an awful amount of time for law to “change”. Nevertheless, I’m paying the tax now. I still believe the rates will be much higher later.

    My question, what do you think about holding real estate investment in self directed Roth IRAs?

    Thanks,

    Cedric

    • Cedric – As you already know, a self-directed IRA that holds investment real estate is possible under the current regulatations. For those not familiar with using real estate as your IRA holdings, this does not include your primary residence.

      It’s a complicated retirement strategy – and you should consult with a tax professional with experience in these situations to help direct the purchase, maintenance, and tax treatment of annual expenses. One wrong move, and a penalty can wipe out the benefits of sheltering a real estate investment under the IRA category.

      My personal and professional knowledge is very limited in this area – but anyone who is interested in more information should find an advisor to help navigate the transactions.

  5. My husband is a grad student full-time, while I stay at home. I contribute to a roth IRA (spousal contribution from his earned income, as I don’t have earned income for the year). According to the tax software I use (H&R freefile), I can take the Saver’s Credit. Does that sound correct to you all? It would be great to claim the credit, but I want to make sure it’s ok. I don’t know what the logic behind the rule that full-time students can’t take the credit is. According to Roth regulations, students can make contributions as long as the money comes from earned income.

    • Zoe – Your question is so specific, I think you should see if H&R Block can provide you further information. The IRS regs specifically exclude anyone who is a full-time student for at least 5 months out of the year – and I assume this is to prevent a young adult who is being supported by parents (even if not a tax dependent) from taking the credit. However, it does not state how a Spousal contribution is treated for the credit.

      This one goes to the tax professionals for the best advice.

  6. Kim Shuni

    Our household MAGI is over 400k we are well over the Roth IRA com. I am a stay at home spouse. Do we qualify for the ‘spousal’ IRA?

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