What is a Roth IRA: Benefits, Limits, and Differences from the Traditional IRA

If you’re anything like me, you don’t like taking risks. I may be too safe for my own good, but I’m just not a thrill seeker. And when it comes to my money, I’m even worse. I don’t play the day-trader game and I don’t like to see any earnings go down the drain. These riskier investment methods aren’t necessarily bad; I just like to know what’s around the corner. Anyone else feel the same way? If so, and you’re looking to save for retirement, the Roth IRA might be for you.

I will attempt to address some of the most commonly asked questions about Roth IRAs, and hopefully shed some light on what can seem like a daunting subject.

The IRA Umbrella

IRA stands for Individual Retirement Arrangement. You will hear it referred to as an Individual Retirement Account, and that’s okay, but technically it’s called an “arrangement,” and the reason is that you can have different accounts under this agreement; it’s not always just one “account.” Think of the Roth IRA as an umbrella: you may have one IRA at your bank and another IRA at your credit union, but they are both part of the same arrangement. Under the umbrella you can have mutual funds to conservatively enter the investment marketplace.

Roth IRA vs. Traditional IRA: What’s the difference?

With a Traditional IRA, contributions are made with pre-taxed dollars and are then taxed at withdrawal. For this reason, your contributions may be tax deductible. You may contribute to a Traditional IRA up until the age of 70 ½, at which time you must start taking a Required Minimum Distribution (RMD).

A Roth IRA’s contributions have already been taxed, so you won’t be able to take a tax deduction. However, you may get to take withdrawals tax-free. You can withdraw the contributions at any time, but you can only withdraw your earnings penalty-free if you have had the account for at least five (5) years and are over the age of 59 ½. (Yes, the IRS likes those half years!) If you don’t meet those two qualifications, then you may have to pay a penalty or tax on your withdrawal. A 10% early withdrawal fee may apply unless you can claim one of these exceptions:

• Disability
• Qualified education expenses
• Qualified first-time home purchase
• Qualified military reservist
• Medical expenses totaling more than 7.5% of Adjusted Gross Income (AGI)
• Substantially equal payments made over life expectancy
• Health insurance, if unemployed for 12 weeks
• Death

Also, you can convert your Traditional IRA to a Roth, but it is an involved process and you will need to seek the help of a qualified advisor.

Can I contribute?

A few pre-requisites apply, but most people are able to contribute to a Roth IRA. Here’s some helpful info:

1. There is no age limit. Unlike the traditional IRA, the Roth has no age limit. Whether you’re 21 or 85, you can contribute to a Roth IRA.
2. You may only contribute earned income. This means reportable wages and tips. If you receive a W2 for it, you can contribute it. But if you get paid solely in cash, or you receive an inheritance, you cannot contribute that income. It must be earned and reported.
3. You have until the tax deadline to contribute for that tax year. For instance, you can make a contribution in March of 2013 and have it go toward the 2012 tax year because it’s before the tax deadline. Just make sure that you specify whether you want your contribution to count for the current or previous tax year.
   
4. Eligibility for contribution goes by your MAGI (Modified Adjusted Gross Income) and changes from year to year. For tax year 2012, it breaks down like this:

• If your tax status is single and you earn less than $110,000, you may contribute up to the full contribution limit. If you earn more than $110,000 but less than $125,000, your contribution allowance is limited by IRS guidelines. If you earn more than $125,000, you cannot contribute at all.
• If your tax status is married and filing jointly and your household income is less than $173,000, you may contribute up to the full contribution limit. If you earn more than $173,000 together, your contributions will be limited by IRS guidelines. If you jointly earn more than $183,000, you cannot contribute.

For the average person, the MAGI limits aren’t something to worry about. But if you think you’re close to the limit and need more information on the MAGI, you can check out the IRS publication (PDF), or consult a tax advisor.

How much can I contribute?

Currently, the maximum yearly contribution is $5,000, or $6,000 if you are 50 years of age or older. This has been the same for years now, but could always change so check it out every year. However, it is important to note that the limit is either the aforementioned set limits, or your earned income, whichever is smaller. Example: if your reportable income last year was $4,500, then the maximum amount you can contribute is $4,500. But if you earned $5,000 (or $6,000 if you’re over 50) or more then you can contribute the full amount as long as you are within the MAGI limits. Make sense?

Will my bank/credit union advise me?

No, they cannot. They can explain the options, but then will refer you to a tax advisor or investment specialist to help you decide what the best option is for you. Your financial institution will also not keep tabs on how much you have contributed to your IRA, or let you know when you’ve reached the limit, or ask to see paycheck stubs to make sure it was all earned legitimately: that’s your job. The institution(s) holding your IRA will report your contributions and withdrawals to the government annually and if Uncle Sam should want to see proof for any reason, it’s your job to provide it to them.

I hope this has helped answer some of your questions about Roth IRAs. It is important to start saving, and the earlier the better. But don’t be afraid of IRAs, they’re really not so scary. The more you know, the better off you will be at retirement. Happy saving!

Have questions about the Roth IRA? Ask them below. We’ll try to answer as many as possible (Readers, pitch in if you know some answers).