Can Anyone Explain How a Roth IRA Works?
Congress passed Roth individual retirement accounts into law in 1997 under the Taxpayer Relief Act. These accounts offer an after-tax retirement account alternative to traditional IRAs, which only offer pretax retirement savings. Knowing how these plans work, and whether you can participate, can increase your retirement account balance.
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Eligibility
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Not everyone can contribute to a Roth IRA. To contribute to a Roth IRA, your modified adjusted gross income must be below the annual limits. These limits vary based on your filing status and change every year. For example, as of 2010 you cannot contribute to a Roth IRA if you are single with a modified adjusted gross income over $120,000. In addition, you cannot contribute unless you have earned income. However, the IRS does not restrict participation based on your age.
Size
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You can contribute up to the annual limit or your earned income for the year, whichever is smaller. The annual contribution limit changes to reflect inflation. As of 2010, the annual contribution limit equals $5,000. If you are 50 or older, your contribution limit increases too $6,000. However, your contribution limit may be decreased if your modified adjusted gross income falls in the phaseout range for your filing status. For example, in 2010 the phaseout range for singles is $105,000 to $120,000; for married couples filing jointly, $167,000 to $177,000; and for married couples filing separately, $0 to $10,000. The closer your modified adjusted gross income is to the upper limit, the more your contribution limit decreases.
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Function
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Contributions made to a Roth IRA cannot be deducted from your taxable income for the year. However, the money in the account grows tax-free and qualified distributions can be taken tax-free. These tax advantages make Roth IRAs best for people who expect to fall in a higher income tax bracket at retirement than they do in the current year.
Time Frame
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Roth IRAs have two requirements that must be met before you can take a qualified distribution. First, the Roth IRA must be at least five tax years old. If the account age requirement is not satisfied, you cannot take a qualified distribution regardless of your age. Second, you must be either 59 1/2 years old, permanently disabled or using no more than $10,000 to buy your first home. You can take qualified distributions tax-free.
Early Distributions
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Early distributions from Roth IRAs may be subject to income taxes and early withdrawal penalties. When you take an early withdrawal, contributions come out first and then earnings come out. Withdrawals of contributions do not count as taxable income. Early withdrawals of earnings count as taxable income and, unless an exception applies, are subject to a 10 percent early withdrawal penalty. Exceptions include medical expenses exceeding 7.5 percent of your adjusted gross income or post-secondary education costs.
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