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The Roth IRA

By: Investor Solutions

By: Investor Solutions, Inc.

If you’re looking for a tax-free investment, the Roth IRA might just be the perfect retirement tool to meet your needs. The concept to the fairly new Roth IRA(introduced in 1998) is that contributions are made with aftertax money, so they are never deductible, however; the attractive feature is that distributions are normally taxfree. Let’s say you are currently age 40 and you contribute $3,000 per year to a Roth IRA over the next 20 years ($60,000 total). Your investment earns 12% per year and grows to approximately $242,000 by the time you reach age 60. With most taxable investments you would owe taxes on the $182,000 gain, but the beauty of the Roth IRA is that the entire $242,000 is yours tax-free, provided you follow the rules.

Contributions to a Traditional IRA might or might not be tax deductible and income taxes on the investment returns are generally deferred until withdrawn from the IRA (the IRS mandates that you must begin distributions from your Traditional IRA at age 70 ½). Using the same example above, and assuming you made the same contributions (now tax-deductible) to a Traditional IRA instead, the full $242,000 would be taxable income to you as you withdraw it from the plan. So why would anyone still want to make contributions to a Traditional IRA? Two good reasons; first maybe the taxpayer is in need of the taxdeductible Traditional IRA contribution, or secondly your earned income level might disqualify you from contributing to a Roth IRA.

In addition to tax-free distributions, the Roth IRA offers two very striking features: no maximum age for making contributions and no required distributions during life. Once death occurs, the minimum distribution rules do apply to the beneficiary of the Roth IRA. So, how can an individual create a Roth IRA? There are two ways: one is to open a Roth IRA at a custodian of your choice and make non-deductible contributions (you must have earned income up to the level of your contribution), and secondly you can rollover your Traditional IRA (called a “Roth IRA Conversion”). Should you opt to do the “Roth IRA Conversion”, this will cause the full amount of the rollover (less any basis) to be currently taxed.

Financial Planning Tip:

For some individuals, converting the full value of their Traditional IRA into a Roth IRA might be too great of a tax hit in one year. For example, assume you have $60,000 in a Traditional IRA that you wish to convert to a Roth. Why not convert $10,000 per year over the next six (6) years, instead of $60,000 all at once. This strategy will only subject you to an additional $10,000 of taxable income per year, it may keep you under the next higher tax bracket!

Whether an individual can make a Roth IRA contribution will depend on certain “compensation” income for the year in question. Compensation income includes: wages, alimony, self-employment income, commissions, professional fees, tips, and other amounts received for professional services. Compensation income does not include gifts, so parents need to be weary about “paying a salary” to their child for household chores, in most cases the IRS will view this as a gift. You can contribute to your Roth IRA up to your compensation income, not to exceed the limits listed below.

Who can contribute to a Roth IRA?

Single Filer Adjusted Gross Income (AGI) Limit
$95,000 or less Full Contribution
$95,001 – $109,999 Partial Contribution
$110,000 and over No Contribution
Married Filing Joint Adjusted Gross Income (AGI) Limit
$150,000 or less Full Contribution
$150,001 – $159,999 Partial Contribution
$160,000 and over No Contribution

What are the maximum annual contribution limits?

Year Contribution Limit Catch-up Contribution*
2002-2004 $3,000 $500
2005 $4,000 $500
2006-2007 $4,000 $1,000
2008-2010 $5,000 $1,000

* Catch-up Contribution: The Economic Growth and Tax Relief Reconciliation Act of 2001 allows Traditional and Roth IRA owners who are age 50 or older by December 31 of the tax year to which the contribution relates to make an additional “catch-up” contribution.

The deadline for making regular Roth IRA contributions for the year is the unextended due date of the tax return for the year in question (for most people, April 15th of the following year). Some individuals may not be eligible to convert their Traditional IRA to the Roth IRA. No conversion is permitted if “the taxpayer’s adjusted gross income exceeds $100,000″ for the taxable year. For married couples filing jointly, the $100,000 applies to the AGI of the couple, not of each spouse. Generally, no conversion is permitted if the taxpayer is married filing a separate return for the year.

Some special rules do apply to Roth IRA’s and they include the following:

  • Funds withdrawn prior to reaching age 59 ½ may be subject to a 10% penalty
  • “Qualified Distributions” must meet a 5-year period inside the Roth IRA (since the first contribution year of the IRA)
  • Removal of regular Roth IRA contributions is NOT a taxable event
  • “Special Purpose Distributions” may be taken up to $10,000 for certain events (i.e. purchase of a first home)

The Roth IRA is a magnificent asset to own. No other investment vehicle offers the ability to invest in the equity and bond markets and generate totally tax-free investment gains that you can withdrawal during your golden years. You are now left to make a decision, which type of IRA is the right IRA for me? If you’re in a low tax bracket, and typically don’t take advantage of the tax-deductible contribution, it’s a no-brainer- Go Roth. However, this is not an easy decision for most IRA owners and should not be taken lightly. Seasoned financial advisors have calculators that help their clients determine the appropriate IRA account. You should consult your financial advisor and tax accountant prior to making any IRA contribution to confirm your contribution limit and to make sure you are utilizing the IRA that is most advantageous for your particular situation for the tax year in question.