A Q&A on Roth IRAs - TheStreet

A Q&A on Roth IRAs

The devil is in the details. And with Roth IRAs, there are a lot of details.
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I discussed traditional IRAs in a series of columns back in August (click

here,

here and

here to read them). And I expected them to generate a lot of questions. But I was surprised so many dealt with a different, though related, subject:

Roth IRAs

.

Most readers know the difference between the two types of IRAs, but that doesn't make either one less confusing. So today's column is a simple Q & A that will, hopefully, cover the basics about Roth IRAs. If this whets your appetite for more in-depth research, check out the Web site

www.rothira.com.

Q.

What is a Roth IRA?

A.

Congress

created the Roth IRA as part of the

Taxpayer Relief Act of 1997

and named it for its sponsor, Sen. William Roth, (R., Del.). It allows you to deposit after-tax earnings into an account that can grow in value tax-free. When you withdraw the money, neither your contributions nor their earnings are taxed. Traditional deductible IRAs allow you to take a tax deduction for the money you contribute, but your contributions and earnings are taxed upon withdrawal.

Q.

If I participate in a retirement plan like a 401(k) or a pension or profit-sharing plan, can I do a Roth?

A.

Yes, as long as you meet the income restrictions and have enough earned compensation.

Q.

What are the income restrictions?

A.

The amount a single person can contribute is phased out for those with adjusted gross incomes between $95,000 and $110,000. For joint filers, contributions are phased out between $150,000 and $160,000. For married taxpayers filing separately, contributions are phased out between $0 and $10,000.

Q.

What is the maximum contribution?

A.

The maximum annual contribution to any type of IRA, Roth or traditional, is $2,000. So if you contribute $1,000 to a traditional IRA during the tax year, that means you can't contribute more than $1,000 to a Roth IRA that year.

Q.

Can a nonincome-producing spouse have a Roth IRA?

A.

Yes. This is called a spousal Roth IRA. The spouse with earned income of $4,000 or more can establish one for the spouse who has no earnings. So a one-income couple can establish two Roth IRAs, each with $2,000. They must be separate IRAs. Joint accounts are not permitted.

Q.

What qualifies as income for a Roth IRA?

A.

It must be earned income. Compensation that qualifies includes wages, commissions, taxable alimony, professional fees, tips, self-employment income and any taxable amount of

Social Security

. It does not include investment income, pensions, annuities, deferred compensation or gifts (including gifts from a parent to a child).

Q.

What is the deadline for making a Roth IRA contribution?

A.

Contributions must be made by April 15 for the previous calendar year. Extensions for Roth IRAs are not allowed even if you obtain one for your tax return.

Q.

Is there an age limit for contributions?

A.

There is no limit. Contributions can be made even after age 70 1/2 (the age limit for traditional IRAs).

Q.

When are you required to take distributions from a Roth IRA?

A.

The Roth IRA owner, assuming he or she did not inherit the account from someone else, has no minimum required distribution or required beginning date. He or she never has to take a distribution. As you know from my previous column, traditional IRAs have a required beginning distribution date and a minimum distribution.

Q.

What kind of assets can I use to fund my IRA?

A.

Cash is the only thing allowed to fund an IRA. You cannot contribute anything else, such as stocks, bonds or mutual funds.

Q.

What is a qualified distribution?

A.

It must meet both of the following two requirements:

1.

You may not take any money out for five years from the time you started investing it. The five-year period starts when the first contribution is made. A significant benefit of this rule is that once the five-year period begins, it begins not only for the initial contribution but also for all future regular contributions.

2.

You meet any of the following conditions:

  • You reach age 59 1/2.
  • You die (in which case your beneficiaries can take the distribution).
  • You become disabled.
  • You purchase a home.

Q.

What are the benefits of a qualified distribution?

A.

It is not subject to federal income taxes and there's no 10% premature distribution penalty.

Q.

What is a nonqualified distribution?

A.

It is a distribution that occurs within the five-year holding period and is not taken for one of the reasons mentioned above. If you take a nonqualified distribution you will pay both federal income taxes and a 10% penalty.

Q.

What if a distribution meets one of the four qualified exceptions but fails the five-year holding period test?

A.

There is no 10% penalty, and there is no tax on your contributions. But earnings on those contributions are taxed.

Q.

Are there any exceptions to the 10% penalty for nonqualified distributions?

A.

Yes. But, again, while your contributions aren't taxed, the earnings on them are. Exceptions are as follows:

  • You reach age 59 1/2.
  • You die (and your beneficiaries take the distribution).
  • You become disabled.
  • You purchase a home.
  • You take the distributions in substantially equal periodic payments, $1,000 a month, for example.
  • Your medical expenses exceed 7.5% of your adjusted gross income.
  • You are unemployed and need to buy health insurance.
  • You need to pay certain higher education expenses.

Q.

How does the homebuyer exception work?

A.

You cannot currently own a home nor can you have owned one for two years prior to the date you purchase your new home. If you're married, your spouse must meet the same rule.

Q.

Can Roth IRA money be used to help somebody else buy a home?

A.

Yes if it's for a spouse, child, grandchild, parents or grandparents. The person buying the home must meet the ownership requirements spelled out above.

Q.

What its the dollar limitation?

A.

There is a lifetime limit of $10,000 for homebuyer distributions.

You probably thought this Roth stuff was easy. Nothing Congress does with tax law is easy. The Roth IRA has some tremendous potential benefits for many people.

Next week, I'll discuss the education exception, highlights of converting a traditional IRA to a Roth IRA and some distribution strategies.

Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at

Hayden@cwixmail.com.