Roth IRAs – Pay Now, Gain Later

A little while back, we talked about IRAs.  But what about Roth IRAs?

They differ from regular IRAs in several ways, notably at the contribution and distribution stages. Unlike IRA contributions which are tax deductible, Roth contributions are not tax deductible.  But a small hit on the front end is designed to yield significant dividends on the back end.  When you go to make a withdrawal from your Roth some years down the road, there is no tax.  More on that later.

Annual contribution limits to a Roth are $5,500 (officially, they’re the lesser of $5,500 or your taxable compensation for the year, but as a practical matter for this purpose, that generally means a cap of $5,500).  If you’re 50 or older, that limit is bumped to $6,500.   Moreover, contributions can be made after one turns 70 ½  — the age at which contributions to regular IRAs must stop.

Note: contributions to other, regular IRAs will count against your annual contribution limit to your Roths.

There are a couple of other limits with Roths.  If you are married, filing jointly, you cannot contribute to a Roth if your modified adjusted gross income (AGI) is $183,000 or more.  For single filers, that cap is $125,000.

Rollovers are possible as well.  You can rollover (or even do a trustee to trustee transfer) from a traditional IRA to a Roth IRA.  Again, what’s the difference between a rollover and a trustee to trustee transfer? With a rollover, the owner takes custody of the funds and puts them back into an IRA (or Roth, in this case) before 60 days expire.  With a rollover from a traditional IRA to a Roth, income from the IRA that would have been included in the taxpayer’s ordinary income for that year had the taxpayer taken a distribution is included in the taxpayer’s income for that year.  This makes up for the deduction that the taxpayer took when he or she made the initial contribution to the IRA; on the flipside, it’s the price exacted from the taxpayer for the favorable tax treatment the end of the life of the Roth.

One final note here.  In this entry, we have made some noise about the fact that distributions from a Roth are tax free. This deserves a brief explanation. The tax favorable treatment applies to qualified distributions only.

A qualified distribution is a payment or distribution from a Roth that:

1. Is made after the 5 year period beginning with the first taxable year for which a contribution was made to a Roth and set up for your benefit; and

2. Is (a) made on or after you reach 59 ½ years of age; (b) made because you are disabled; (c) made to a beneficiary or to your estate after your death; or (d) meets other exceptions concerning the purchase of a first home.

Owners of Roth IRAs should be mindful of early distributions, just as with regular IRAs.  Early distributions are subject to a 10% additional tax; on the plus side, there is no requirement that one takes minimum distributions, although the exception is if the distribution occurs after the Roth owner’s death; then the IRA minimum distribution rules apply.