A simple guide to the Roth IRA—find out what it is and who can use it to grow a retirement nest egg.
If you’re a regular on the Money Girl podcast or web site, you know that you should be saving for retirement. But sometimes it seems difficult to get started because you have to make some important decisions, like what type of retirement account to use.
This is the first episode in a 2-part series about the Roth IRA retirement account. Today, we’ll cover what it is, who can have one, and the withdrawal rules.
Then in part 2, you’ll find out when you should opt for a Roth IRA, the types of investments a Roth is ideally suited for, and where to get one.
What Is a Roth IRA?
IRA is short for Individual Retirement Arrangement, and it’s a special kindof account that allows you to save and invest for retirement while getting some very nice tax breaks. There are 2 main types: a traditional IRA and a Roth IRA.
When you contribute money to a traditional IRA, it’s generally tax-deductible. That means you don’t pay tax on the money you put in the account, which lowers your tax bill in the current year. Instead, you’re allowed to defer taxation on both contributions and earnings until you make a withdrawal during retirement.
With a Roth IRA, you have to pay tax upfront on your contributions. However, the account grows completely tax-free. That means you never pay tax on your investment earnings when you pull money out during retirement.
There are other differences between these accounts, but the major distinction is how and when your contributions and their growth are taxed. Again, with a traditional IRA money is taxed when you withdraw it, and with a Roth IRA money is taxed before you put it in.
An IRA itself is not an investment; it’s just a special type of tax-advantaged account. This concept trips up a lot of people who think that an IRA is only for those who want to invest in the stock market.
Think of an IRA like an umbrella that shelters what’s underneath from taxes. What you put under your IRA umbrella is up to you and there’s a wide range of choices. For instance, if you’re very conservative you could choose CDs, treasuries, or bonds. For more growth, you could opt for index mutual funds or exchange-traded funds. And if you like a more aggressive approach, you can choose individual stocks or stock mutual funds.
There are even self-directed IRAs that allow you to own real estate or businesses inside an IRA—but we’re just going to stick to the basics in this article.
How Much Can You Contribute to a Roth IRA?
How much you can contribute to an IRA is determined by the IRS each year. For 2012, you can contribute an amount equal to your earned income up to $5,000. If you’re age 50 or older, you can contribute up to $6,000.
For instance, if you earn $3,000 from a part-time job, you could contribute a maximum of $3,000 to an IRA. But if you’re younger than 50 and make $100,000 in 2012, you’re still limited to IRA contributions of $5,000.
You can make contributions to a traditional IRA, a Roth IRA, or to both in the same year, as long as you don’t exceed your total allowable limit. For instance, you could contribute $2,000 to a traditional IRA and $3,000 to a Roth IRA. You can even contribute to an IRA if you participate in a retirement plan at work.
The deadline for IRA contributions is the tax deadline in the following year. So you have until mid-April of 2013 to make IRA contributions for 2012.
Related Content: 15 IRA Rules You Should Know
What Are the Roth IRA Eligibility Rules?
Now that you know the Roth IRA basics, let’s cover the rules about who can have one. Unlike a traditional IRA, there are income limits on who can make a Roth IRA contribution. The restrictions can change from year to year, but here are rules for 2012:
If you file taxes as a single and your modified adjusted gross income is higher than $125,000, you cannot contribute to a Roth IRA. When you earn from $110,000 to $125,000, your contribution total is phased out or reduced.
If you’re married and file taxes jointly, you cannot contribute to a Roth IRA when your household’s joint modified adjusted gross income exceeds $183,000. And when you earn from $173,000 to $183,000, your contribution total is reduced.
If your income is too high to make a Roth contribution, but you have a traditional IRA, you can convert it into a Roth IRA. Since money in a traditional IRA was never taxed, doing a Roth conversion means that you have to pay income tax on the full amount that you convert.
You still can’t make new contributions to a Roth IRA when your income is too high, but you enjoy the account’s tax-free growth.
Related Content: Rules for Using a Spousal IRA When You Have No Income
How to Make Withdrawals From a Roth IRA
You may be wondering how the Roth IRA stacks up against a traditional IRA when it’s time to take money out. The Roth definitely offers more flexibility:
With a traditional IRA, withdrawals you make before age 59½ are generally subject to ordinary income tax plus a 10% early withdrawal penalty.
With a Roth IRA, you can withdraw contributions at any time without having to pay income tax or a penalty—because you already paid tax on them. However, your growth in the account (the money your contributions earned) has not been taxed. So withdrawing any amount of earnings before age 59½ means they’re generally subject to income tax plus a 10% penalty.
Another major distinction between these accounts is that a traditional IRA requires you to start taking money out at age 70½, whether you need it or not. But a Roth IRA doesn’t impose any minimum distributions, which means you can leave the money in the account as long as you want or easily pass it on to your heirs.
As you can see, traditional and Roth IRAs both have advantages that can work in your favor depending on your financial situation and goals.
In Part 2 of this series, we’ll take a closer look at who gets the most benefit from a Roth, the best places to open one, and which investments allow you to save the most on taxes when you own them inside a Roth IRA.
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