Saving for retirement isn't the only reason to put money in a Roth IRA. These powerful vehicles can also be used as an estate planning device, a first-home fund or a college savings account. As long as you have earned income, you can fund a Roth regardless of your age or whether you participate in a retirement plan at work. Although you pay tax on money before you sock it away, withdrawals are tax-free after you reach 59½ and in some cases before that.
But many people find Roths confusing and shy away from them, says Ed Slott, publisher of Ed Slott's IRA Advisor. True, there are some complicated provisions, such as the five-year test for withdrawals, but most people don't have to worry about them as long as they leave their money in a Roth long-term.
Here's help understanding the basics, and the complications, of Roth IRAs.
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A review of the basics
You must have earned compensation to open a Roth, and your adjusted gross income must be less than $110,000 on a single return or $160,000 on a joint return. The amount you can contribute is reduced as your AGI exceeds $95,000 (single return) or $150,000 (joint return). For example, if you're single and your AGI is $100,000, the amount you can contribute is reduced by about $1,000.
Use the worksheet for figuring your contribution limit in IRS Publication 590 (PDF, 438KB), Individual Retirement Arrangements. If you exceed the limit, excess contributions will get hit with a 6% tax -- unless you take action (see "Excess Contribution Remedy").
Contribution limits. Individuals can contribute up to $4,000 annually to a Roth, and married couples up to $8,000. In 2008, the limit will increase to $5,000 ($10,000 for couples). If you're 50 or older, there's a special "catch-up" provision that lets you contribute $500 more than the regular limits. In 2006, the catch-up bonus increases to $1,000.
Tax benefits. You can't deduct Roth contributions on your tax return, but you can withdraw the money tax- and penalty-free once you've turned 59½ and have had the account for at least five years. (With a traditional IRA, any pre-tax money you put in will be taxed as income when you withdraw it.) Lower-income workers might qualify for a tax credit for a percentage of their contributions (see "Boost Your Retirement Savings").
Distributions. Unlike with a traditional IRA, you don't have to take mandatory distributions once you turn 70½.
The advanced course
Contributions can be withdrawn tax- and penalty-free at any time. "That's what makes Roth IRAs great -- you can always pull your money out," Slott says. The complications arise when you want to withdraw earnings.
To withdraw earnings tax- and penalty-free, you must pass the five-year test and meet at least one of the following conditions:
- You're at least 59½ years old.
- You plan to use the money to buy a first home for yourself, your spouse, your kids, your grandkids or your parents (subject to a $10,000 lifetime limit).
- You become disabled (penalties are also waived for your estate if you die).
If you withdraw the money without meeting the five-year test, you can avoid the 10% penalty (but your earnings will still be taxed) if you:
- use the money to pay qualifying college costs.
- take out up to $10,000 for a first-time home purchase.
- pay qualifying, unreimbursed medical expenses that are greater than 7.5% of your adjusted gross income .
- buy health insurance while unemployed (you must be on unemployment for 12 weeks).
- take a series of substantially equal payments (based on life expectancy) for at least five years and until age 59 1/2.
Conversions and un-conversions. You can convert a traditional IRA to a Roth if your AGI is less than $100,000 (that limit applies whether you're single or married filing jointly, and you can't convert an inherited IRA or if you're married filing separately). A conversion will make all future earnings tax-free rather than simply tax-deferred. However, all of what you convert will be taxed. For example, converting $100,000 would cost $25,000 in the 25% bracket. You can lower the tax hit by converting just part of your IRA to a Roth each year over several years.
Does it make sense to pay now to buy tax savings later? Slott thinks so. "Clients think they get beaten when they pay taxes on conversion," he says. But if they didn't convert, the account would grow and they likely would pay even more in taxes when they withdrew the money in retirement. This calculator will help you decide if you should convert. For more, see "Get the Most Out of Your IRA."
Note that you can also undo a conversion -- a smart move if you have lost a lot of money in your Roth. Your best bet is to wait until near the end of the year to see how the account is doing. If it's still down, you can move your money back to a traditional IRA. In 30 days, you can convert back to a Roth to reduce the tax bill.
Excess contribution remedy. When you contribute to a Roth or convert a traditional IRA to a Roth, then discover that you've exceeded the income limit, it's easy to avoid penalties. If you've simply contributed too much for your income, you can withdraw the excess without penalty as long as you do it before you file your tax return. Contact your IRA sponsor for details.
If you've converted a traditional IRA to a Roth, the solution is to switch back to a traditional IRA by "recharacterizing." You must recharacterize by October 15 of the year following the conversion.
College savings catch-22. A Roth IRA can be a good place to put college savings, but it can affect financial aid. Roth assets -- just like the assets of any qualified retirement plan -- are excluded from the federal financial aid formula. But withdrawals to pay for college are considered parental income, which is taken into consideration when figuring aid, says Joseph Hurley, founder of Savingforcollege.com.
If you convert from a traditional IRA to a Roth at the time you're applying for financial aid, that can count against you, too -- even if you aren't using the money for college -- because it boosts your taxable income.
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