What I Need to Know About a Roth IRA

IRA stands for Individual Retirement Account, and there are two primary types of IRAs: Traditional and Roth. There are many similarities between the two, but also some key differences, that might make one or the other better for you.

Contributions

For tax year 2010, you can contribute up to $5,000 to either your Roth IRA or Traditional IRA. These limits are set to increase to $6,000 for tax year 2011, and you have until April 15 of the following tax year to make your contributions for the prior year. Traditional IRAs allow you to include these contributions on your taxes as a deductible expense. Roth IRA contributions, however, are not tax deductible or tax advantaged, meaning you have to fund these contributions with after-tax income. However, with a Roth IRA you may withdraw the amount attributable to your after-tax contributions at any time with no penalty. With a Traditional IRA, with certain exceptions, you will pay a 10 percent penalty on any withdrawals prior to age 59 1/2.

Taxation of Withdrawals

In both the Traditional and Roth IRA you will not pay taxes on investment income while it remains in the plan. However, as you do not pay taxes on your contributions to a Traditional IRA, all distributions are taxed as ordinary income. Distributions from Roth IRAs are not taxed. This is the key benefit to the Roth IRA. However, if you take distributions of investment income from your Roth IRA, over and above your contributions, before reaching age 59 1/2 and having participated in the IRA for at least five years, you will pay a 10 percent penalty just as you would with a Traditional IRA

Income Limits

Since Roth IRAs have tax advantages, particularly on qualified withdrawals, there are some limits to how much you can earn to participate in a Roth IRA. To participate in a Roth IRA and make contributions for tax year 2010, a single tax payer's Adjusted Gross Income (AGI) must be less than $120,000 and less than $177,000 for married couples filing jointly. However, if you previously did not earn at this level and have an existing Roth IRA, you are allowed to maintain it -- just not make new contributions. These AGI limits will increase each year to accommodate inflation. There are no income limits for participating in a Traditional IRA, but the tax deductibility of contributions to Traditional IRAs may phase out depending on your tax filing status, AGI and whether the plan is sponsored by an employer or not.

Withdrawal Requirements

There are no requirements for when you must begin withdrawals from your Roth IRA. You can even pass a Roth IRA down to your children.

This differs greatly from Traditional IRAs where withdrawals are required to begin before you reach age 70 1/2. Additionally, there are minimum withdrawal requirements for Traditional IRAs. These are determined by the amount in your account and your life expectancy. If either of these items are not adhered to, there are severe tax penalties of 50 percent of your required minimum distribution amount.

Conversion

You can convert a Traditional IRA to a Roth IRA. However, the conversion amount, less any after-tax contributions you may have made to your Traditional IRA, will be taxed as ordinary income. For conversions taking place in 2010, you are permitted to pay the taxes owed on the conversion over the next two years. There are income limits, but even if you are above those limits, you can convert to a Roth IRA -- just not contribute additional funds.

References

• Good Financial Cents: 7 Things To Know About The 2010 Roth IRA Conversion Rules
• Bright Hub: 2010 Roth IRA Limits Contributions and Following Years
• IRS.gov: Roth IRAs
• Good Financial Cents: 2010 Traditional IRA to Roth IRA Conversion Tax Rules
• IRS.gov: 2010 IRA Contribution and Deduction Limits
• Motley Fool: All About IRAs for First-Time Homebuyers

Resources

• IRS Publication 590