| All About IRAs | ||||
Original link: http://www.fool.com/money/allaboutiras/allaboutiras.htm By David Wolpe (TMF DBunk) The Individual Retirement Account (IRA) brings together two tremendously powerful forces, both of which benefit you: 1) compound interest, and 2) tax savings. If you've got money that you can afford to invest for the long term, there's really no reason not to open an IRA. Lethargy is not a good reason. Inertia is not a good reason. Keeping your eyes wide shut about your future is not a good reason. Compound interest becomes even more powerful when it is not held back by the drag coefficient of taxes. In those golden years, you want to be able to go out and buy the gold-plated golf clubs, jet out to Hawaii to circle the big island on a dolphin's back, savor the flavor of fine French food, make generous contributions to a cause that stirs your passions, or hire a trainer to help you get in shape for your Space Shuttle mission. You also want the opportunity to become your family's Most Beloved Ancestor -- the more you save, and the more you have at the end of the day, the more you're likely to have left over to spread around to your heirs. So you're really doing everyone a favor -- yourself included. The language of IRAs is often clouded with terms like "AGI" and "minimum distributions" and "rollovers." Yes, you'll find those self-same terms here, but we'll do our best to make it all meaningful and digestible. To that end we've added a little glossary to have as a handy reference. So, here we present most everything you'd like to know about IRAs. Your mouth will drop open in glad delirium as you learn that there are actually 11 (count 'em, 11!) types of IRAs. You'll find out about the eight exceptions to the 10% penalty. You'll journey through the land of Roth, and determine whether you should take advantage of the IRA that carries its name. (Hey! This is starting to sound like an epic!) You'll learn about Education IRAs, contribution/deduction limits, and rollovers. What is an IRA, anyhow? An Individual Retirement Arrangement (IRA), commonly called an Individual Retirement Account, is a personal retirement savings plan available to anyone who receives taxable compensation during the year. For IRA contribution purposes, compensation includes wages, salaries, fees, tips, bonuses, commissions, taxable alimony, and separate maintenance payments. Husbands and wives may each have an IRA, even if one person in that marriage is not working. One person's annual contribution, whether made to just one or to multiple IRAs, is limited to the lesser of total taxable compensation or to the normal yearly amount shown in the following table. Persons age 50 or older may make an additional catch-up contribution in the amount indicated in the table below. Traditional and Roth IRA Annual Contribution Limits Year Normal Catch-up ---------------------------- 2001 $2,000 $0 2002 $3,000 $500 2003 $3,000 $500 2004 $3,000 $500 2005 $4,000 $500 2006 $4,000 $1,000 2007 $4,000 $1,000 2008 $5,000 $1,000 2009+ Indexed* $1,000 *Normal contribution limits will increase annually by $500 whenever cumulative inflation exceeds the next higher $500 increment. There is no minimum or required IRA contribution, and all earnings on the amounts in an IRA are untaxed until withdrawn. In the case of the Roth IRA, withdrawals may even be tax-free provided certain minimum rules discussed later are met. Contributions to a Roth IRA are never tax-deductible. Contributions to a traditional IRA may or may not be deductible in the tax year made, depending on the owner's income tax filing status, adjusted gross income (AGI), and eligibility to participate in a tax-qualified retirement plan through employment. If the traditional IRA owner participates in an employer's qualified retirement plan on any day in the tax year, the deductibility of contributions declines to zero between certain AGI ranges as shown in the following table. AGI Phase-Out
Limits for Deductible Traditional IRA
Year Single Filer Joint Filer
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2001 $33,000 - $43,000 $53,000 - $63,000
2002 $34,000 - $44,000 $54,000 - $64,000
2003 $40,000 - $50,000 $60,000 - $70,000
2004 $45,000 - $55,000 $65,000 - $75,000
2005 $50,000 - $60,000 $70,000 - $80,000
2006 $50,000 - $60,000 $75,000 - $85,000
2007* $50,000 - $60,000 $80,000 - $100,000
* 2007 and later A working spouse not covered by a retirement plan through employment may make a tax-deductible contribution of up to $2,000 annually to an IRA despite the other spouse's coverage under an employer-provided retirement plan. When the couple's AGI reaches $150,000, deductibility for such contributions begins to decline, and it reaches zero at a joint AGI of $160,000. Money may be withdrawn from an IRA at any time, but on withdrawal it may be taxed and/or penalized. Withdrawals from a traditional IRA will always be taxed, either in whole or in part, at ordinary income tax rates. Except as noted below, withdrawals from a traditional IRA prior to age 59 1/2 will result in a 10% excise tax as well as an ordinary income tax. The potential income taxes and early withdrawal penalties on Roth and Education IRA withdrawals will be discussed in subsequent articles. If nondeductible contributions were made to a traditional IRA, part of any withdrawal from that IRA will not be taxed. The calculations for deriving the taxable and nontaxable part of the withdrawal are too complicated to cover here. For those who may face this problem, the IRS has a handy-dandy way to make that calculation. It's called Form 8606, a tax document that must be completed and filed with your income tax return to report both nondeductible traditional IRA contributions and withdrawals whenever they occur. Mandatory distributions for traditional IRAs must begin no later than April 1 of the year following the year the IRA owner reaches age 70 1/2. Failure to take required minimum distributions at that age results in a 50% excise tax on the amounts not distributed. Roth IRAs have no mandatory distribution requirement, but Education IRAs do as discussed here. There are eight exceptions to the 10% penalty for IRA withdrawals prior to age 59 1/2. The early withdrawal penalty does not apply to distributions that:
Except as noted in later discussions on Roth and Education IRA distributions, ordinary income taxes are still due and payable on IRA withdrawals taken under any of the above exceptions. So how many kinds of IRAs are there, anyhow? Would you believe ... 11? There are 11 (count 'em, 11) types of IRAs. There are individual IRAs, Group IRAs, SEP IRAs... Do any of these sound familiar? Of course they do! You've often scratched your head and wondered aloud in the still of the night, "What's SEP, anyhow?" Your spouse, naturally, thinks you're asking, "What's up, anyhow?" and, rolling over and grumbling, can't understand why you would want to raise that question just then. This has no doubt been the source of many a midnight spat between the two of you. You say, "SEP-IRA." Your spouse rolls over and says, "You made me roll over again." Back and forth it goes: SEP-IRA? Rollover. SEP-IRA? Rollover. And so it continues, on and on, until at last the two of you end up either at a marriage counselor or as reluctant subjects in a sleep deprivation study. In order to save you and your spousal unit from this fate, then, we present the 11 types of IRA (including, of course, the Spousal IRA):
A "qualified" distribution from a Roth IRA is a withdrawal that meets one or more of the following:
No withdrawal except those attributable to previously taxed contributions will be a qualified distribution unless it is made after the five-tax-year period beginning with the tax-year in which the taxpayer first contributed to a Roth IRA. Annual contributions to a Roth IRA are subject to the contribution limits shown previously in "All About IRAs" as reduced by any contribution made to a traditional IRA. Contributions to a Roth IRA may be made even after the owner reaches age 70 1/2. The annual contribution limit is phased out as AGI increases from $150,000 to $160,000 (married filing jointly) or $95,000 to $110,000 (single filer). Amounts in traditional IRAs may be transferred to Roth IRAs provided the taxpayer's AGI (married or single) for the transfer year is $100,000 or less. Transferred amounts must be included in that year's income, but the money transferred will be exempt from the 10% excise tax for a withdrawal prior to age 59 1/2. No withdrawal allocable to earnings on the transferred amounts is considered to be a qualified distribution unless it is made more than five tax-years after the transfer. Further details on IRA provisions may be found in IRS Publication 590, Individual Retirement Arrangements. This publication may be obtained at no cost by calling 1-800-TAX-FORM or downloading it online Of course it's true that there are 11 types, but the two we hear the most about are the traditional IRA and the Roth IRA. What, in a nutshell, is the difference? Well, here's the nutshell. Traditional IRAs For example, let's say you made $30,000 during the year, and you put $2,000 of it into an IRA. You would pay income tax on only $28,000. Additionally, your deposit will grow free of tax through the years. When you finally withdraw the money for your retirement -- after age 59 1/2 -- then, and only then, will the money be taxed as income at your ordinary income tax rate. If you withdraw the funds before age 59 1/2, then in most cases you'll have to pay both income tax and a 10% penalty on whatever earnings have accrued -- but if the funds are used to pay for "qualified higher education expenses" or for one of the other eight exceptions to the 10% early withdrawal penalty, then the penalty will be waived. Remember that you can put just about anything you want in an IRA account. Under the onslaught of marketing from banks, you may have come to the conclusion that an IRA is somehow connected to a CD (certificate of deposit). This is because that is what most banks sell. But be advised, Fool: You're not limited to what the banks offer. If your outlook is Foolish, and you'd like to take control of your investing future, and you think you can develop some market-beating returns, then by all means, plunge ahead, with IRA and tax savings happily in hand! The Roth IRA In other words, the Roth offers tax-exempt rather than simply tax-deferred savings. One word makes a big difference. While both allow you to accumulate wealth without paying taxes along the way on your profits, the traditional IRA ultimately sticks you with a tax bill for those profits (plus your initial contributions if those were deducted when made). The Roth doesn't. As long as you follow the rules, you never pay taxes on your gains. So paying the piper now before contributing to the Roth may work out to be better for you than paying him later on your investment profits. The Roth makes particular sense for people otherwise limited to making non-deductible contributions to a regular IRA. And the Roth is fully available to single filers making up to $95,000 and couples making up to $150,000. It also allows you great flexibility by allowing you, in many cases, to withdraw your principal contributions at any time tax-free, without penalty. First-time homebuyers can also pull out $10,000 in profits penalty free and tax-free if the money has been in the Roth IRA for at least five tax years. There are also some breaks for education spending, though an Education IRA may be a better vehicle for education savings. Barring these exceptions, though, profits withdrawn before retirement age and before the money has been in the Roth for at least five tax-years will be taxed, plus you'll also incur a 10% penalty when those earnings are taken before age 59 1/2. You can plug in your own numbers to compare the two types of account by using our Regular IRA vs. Roth calculator. To Convert or Not to Convert In general, if you have to use your IRA savings to pay taxes triggered by shifting them to a Roth, then you may be sacrificing too much principal up-front to make the deal worthwhile, unless you have many years to make up for this dip into your savings. You should also note that funds rolled over into a Roth IRA come under greater restrictions for penalty-free and tax-free distributions as compared to normal Roth IRA contributions. Want to make a quick conversion comparison? Then just click on another handy calculator, Should I convert my IRA?, to plug in your own numbers and see if conversion is for you. The Roth IRA ContributionsIt seemed like such an easy concept when it was first introduced back in 1997: Put some money away for a while and then take those funds and earnings out tax-free at some time in the future. But, like most tax issues, the Roth IRA has turned into a monster. And while the concept may still remain an easy one to understand, the actual rules and regulations have become very complex. In the next few articles we'll review the Roth IRA in greater detail and try to make things clear. Let's get started. An individual may make an annual nondeductible contribution to a Roth IRA that may not exceed the smaller of the maximum allowable annual IRA contribution or 100% of the individual's earned income for that year, minus the total of all contributions for that tax-year to all other individual retirement plans (other than Education IRAs) owned by that person. What this means is that your total contributions for the tax-year to a traditional IRA and a Roth IRA may not exceed the total contribution allowed for that year. So, in effect, you'll want to determine which savings vehicle is best for you (Roth or traditional IRA), and place your allowable contribution in the appropriate IRA. While the law certainly doesn't prohibit you from placing, for example, $500 in a Roth IRA and $1,500 in a traditional IRA, the administrative hassles and fees of this type of arrangement are not negligible. But because of the Roth IRA phase-out rules (that we'll discuss below), "splitting" your allowable IRA contribution into a traditional IRA and a Roth IRA may be your only option if you want to make a full contribution for that year. A couple of distinctions to note:
Example: John is a single taxpayer. In 2001 he will make $50,000 in earned income. John is also a participant in his company's pension plan. Additionally, John will contribute the maximum amount to his employer's 401(k) plan. In his spare time, John has a consulting job and will earn additional business (Schedule C) income in the amount of $15,000. John will make a maximum SEP IRA contribution based upon his net business income. John also makes an Education IRA contribution for the benefit of his daughter. Even with all of these tax-deferred savings and investment vehicles, John can still make a $2,000 Roth IRA contribution for 2001. It should also be noted that any amounts converted to a Roth IRA (which we'll discuss next) in a "qualified rollover contribution" are not counted toward the maximum annual contribution limit. So in the example above, even with everything John had going on, he could make a "qualified rollover contribution" and still have the choice of making a $2,000 Roth IRA contribution for 2001. Income Limitations Single and Head of Household Filers When AGI rises above $110,000, no Roth IRA contribution is allowable. Between the $95,000 and $110,000 phase-out range, only a partial Roth IRA contribution will be allowed. (For details on computing allowable IRA contributions in the phase-out range, see IRS Publication 590, Individual Retirement Arrangements.) Joint Filers When AGI rises above $160,000, no Roth IRA contribution is allowable. Between the $150,000 and $160,000 phase-out range, only a partial Roth IRA contribution will be allowed. (For details on computing allowable IRA contributions in the phase-out range, see IRS Publication 590, Individual Retirement Arrangements.) Married Filing Separately What the Heck is a Phase-Out Range? Example: Jill -- a single person -- has an AGI of $105,000, has earned income of at least $2,000, and is not a participant in her employer's pension/profit sharing plan. Since Jill is two-thirds into the phase-out range, she is only allowed a one-third contribution to her Roth IRA. Therefore, her maximum Roth IRA contributionfor 2001 would amount to $666.67 (which she can round up to $670). Since her Roth IRA was limited, can she make a traditional IRA contribution? Sure... in the amount of $1,330. Will that IRA contribution be deductible? That will depend on Jill's circumstances. In our example, Jill isn't a participant in her employer's pension/profit sharing plan, so her traditional IRA would be fully deductible. If she were a participant in her employer's pension plan, her deductible IRA contribution would be limited as discussed here. You should be aware that there are no age limits on contributions to a Roth IRA. A young child with earned income can make a Roth IRA contribution if it is deemed appropriate. Also, unlike a regular IRA, persons over the age of 70 1/2 can still make Roth IRA contributions as long as they have earned income and are not otherwise restricted by the AGI limitations. And, unlike a regular IRA, a Roth IRA is not subject to the "required minimum distribution" rules that require minimum IRA distributions when you turn age 70 1/2. Remember that Roth IRA contributions for a tax-year must be made no later than the due date of your tax return, not including extensions. So if you are qualified to make a 2001 Roth IRA contribution, that contribution must be made no later than April 15, 2002, the due date of your tax return. For many people, the Roth IRA is clearly the better choice over a regular IRA. However, what if you already have a traditional IRA? Can you wave your magic wand and turn it into a Roth? Perhaps... it depends on whether your wand meets certain conditions. Conversion must be qualified Adjusted gross income limitations This $100,000 limitation applies not only to single filers, but also to married people filing jointly and head-of-household filers. Furthermore, don't think you can beat the AGI limitations by filing a married-separate tax return. You can't. The law specifically states that if you are a married taxpayer filing a separate tax return, you may not convert your traditional IRA to a Roth IRA, regardless of your AGI. (Note: What if you made a Roth conversion last January and now find that your AGI will exceed the $100,000 limitation? First, don't panic. You have the ability to "re-characterize" your Roth IRA back to a traditional IRA without penalty if you follow a few simple steps. Second, read more about how to follow those steps in our Tax Area article "Recharacterizations.") And remember that the AGI limitations are computed without regard to the amount of the conversion. Example: Jack, a single person, has an AGI of $75,000. Jack also has a traditional IRA in the amount of $60,000 that he wants to convert to a Roth IRA. For AGI limitation purposes, Jack's conversion threshold is $75,000 (the amount of his "normal" AGI, without regard to the conversion amount), and not the total of his "normal" AGI and his "conversion" amount. Jack's AGI for income tax purposes will change if he decides to make this conversion, but that's an issue that we'll discuss in detail a little later. Conversion Taxation Issues In effect, the funds converted from the traditional IRA to the Roth IRA that would have been taxable had the distribution not been part of a qualified conversion will be subject to income tax at your normal tax rate. If your IRA consists only of prior deductible contributions and the earnings thereon, the total amount of the conversion will be subject to taxation. If part of your IRA consists of prior nondeductible contributions, they will not be taxed again at the time of the conversion. And if your IRA consists of funds from a prior rollover from another qualified pension plan (such as a pension/profit sharing plan, 401(k) plan, 403(b) plan, Keogh plan, SEP plan, etc.), all of the funds will be taxable to you at the time of the conversion. No penalty: Because the conversion is "qualified," the 10% penalty for an early withdrawal from an IRA account will not be imposed. In effect, the conversion can be made without paying the 10% IRA early withdrawal penalty. But should you decide to remove these converted funds "early" from the Roth IRA, you may be subject to a penalty. Early withdrawal penalty issues are discussed here. Confused? No need. Let's continue with the example of Jack and his conversion. Example: Jack's AGI is $75,000, and he made a $60,000
conversion from his regular IRA to a Roth IRA this year. Now Jack's AGI
for income tax purposes will be $135,000 (his regular AGI of $75,000 plus
all of his conversion income of $60,000). Jack decided to pay more tax dollars to Uncle Sammy right now. In
effect, Jack is trading tax dollars now for the tax-free status of the
Roth earnings in the future. Is that appropriate? Perhaps for Jack, based
on his personal situation, the answer is yes. But it is not necessarily
appropriate for everyone. In fact, for some people, converting a regular
IRA to a Roth IRA might actually cost them additional tax dollars
in the long run. You can find Roth IRA conversion "calculators" all over the Web to help
you with your decision (test several or read reviews first to make sure
the calculator you use matches your personal situation best -- not all
calculators are created equal). We have two useful calculators in our
Retirement area to take you through the decisions about "
Which is better: Regular IRA or Roth IRA?" and "
Should I convert my IRA into a Roth IRA?" We've now reviewed the provisions in the law regarding the Roth IRA contribution (putting your cashin) and eligibility rules (the stick). Here we'll review the tax treatment of qualified distributions (getting your cash out) from the Roth IRA (the carrot). Qualified Distributions To be qualified, the distribution MUST be:
But -- and this is a very big but -- even if one of the qualifications above is met, the distribution is STILL not qualified if it is made within a five-tax-year period. We'll see how to compute the five-tax-year holding period a bit later. Just know that five tax-years are NOT necessarily the same as five calendar years. So, in effect, there are two sets of rules that must be met before a Roth IRA distribution becomes qualified, and therefore tax-free: The distribution rules and the five-tax-year rules. Unless both sets of rules are met, the distribution will NOT be qualified, and the earnings will be subject to tax, and possibly penalties. We'll discuss penalties in detail in the next article. Example #1: Bill, who is 25, makes a Roth IRA contribution of $2,000 this year. Seven years later (well beyond the five-tax-year period), Bill closes his Roth IRA and takes a distribution in the total amount of $4,500 (representing the original $2,000 contribution and $2,500 in earnings). Bill is not disabled, nor does he use these funds to pay first-time homebuyer expenses. Since Bill is NOT over age 59 1/2 when he takes the distribution, the distribution is NOT qualified. Bill will owe income taxes on the $2,500 of earnings. Additionally, Bill will be assessed a 10% early withdrawal penalty on this $2,500 of earnings unless he meets one of the other six authorized exceptions for avoiding that penalty. Ouch. Remember that, under the Roth IRA rules and unlike the rules for a
regular IRA, you can first remove your contributions
without tax or penalty. So, in Example #1 above, if Bill decided to take a
withdrawal of only $2,000, it would be treated as a distribution of his
original contributions, and would not be subject to taxes
or penalties. That only makes sense since Bill didn't get to deduct that
contribution from his taxable income when it was originally made (so, he's
already paid income tax on the money). The Five-Tax-Year Rule Example #2: Mike, at age 57, made a $2,000
contribution to his Roth IRA on April 15, 1999 for tax year 1998. On Jan.
2, 2003, Mike withdraws $3,000 from his Roth IRA when he is over age 59
1/2. Of the $3,000 withdrawn, $2,000 represents the original contribution,
and $1,000 represents the earnings. Roth IRA early withdrawals and penaltiesNow that we have discussed contributions, conversions, and qualified distributions, we will now look at the distribution ordering rules and penalties on "early" withdrawals from a Roth IRA. IRS Ordering Rules
Who cares? You might -- especially if you find that you have to take an early withdrawal. Let's look at some examples. Penalties on Earnings from Contributions Example #1: Jim, age 30, made a Roth IRA contribution of $2,000 in 1998. In 2005, Jim's Roth IRA has a balance of $3,500. Jim decides to close his Roth IRA in a non-qualified distribution that year. Since the distribution is non-qualified, Jim will owe taxes on his Roth earnings of $1,500, and will pay tax on this amount at his marginal tax rate. In addition, since the distribution took place before Jim reached age 59 1/2, and since Jim did not meet any of the exceptions, Jim will also be assessed a 10% early withdrawal penalty on the earnings. If we assume that Jim is in the 28% marginal tax bracket, he will pay $420 in tax on the earnings, and will pay a penalty in the amount of $150 on the early distribution. This is a very steep price to pay. Exceptions
Penalties on Conversions From a Traditional IRA to a Roth IRA
Example #2: Paul made a $20,000 conversion from his regular IRA to a Roth IRA in 1998. The entire amount converted was includable in Paul's income for 1998. Paul made no additional contributions or conversions to a Roth IRA in 1998 or in later years. In 2001, before he is age 59 1/2, Paul withdraws $10,000 from the Roth IRA. Paul will have no tax to pay on this withdrawal because he paid income taxes on the full $20,000 he converted in 1998; however, he WILL have to pay a 10% penalty (or $1,000) unless one of the IRA early withdrawal exceptions apply. Why? Because Paul didn't keep the conversion amount in his Roth IRA for the required five-tax-year period since his original conversion.
So, if you are going to take funds "early" from your Roth IRA, weigh
your conversion decision very carefully -- especially if you made
non-deductible contributions to your original IRA. If you did
make non-deductible contributions to your regular IRA, you'll generally be
worse off by converting to a Roth IRA and taking the funds early than you
would be by simply taking the funds from the regular IRA. Not quite clear on how this works? Let's take a look at an example:
On the other hand, if you are reasonably young (under age 50) and
expect to need to withdraw funds from your IRA in five years (and can't
use any exceptions to avoid the 10% penalty), you might be better off
converting funds from your regular IRA to a Roth IRA now. If you wait
until after the five-tax-year period to withdraw money
from a Roth IRA, the 10% penalty won't be imposed, even if you aren't yet
59 1/2 and don't meet any other exception to the penalty.
Still not clear on this? Another example might be in order: But what if Rick took a distribution of $20,000 in 2007? In that case,
he would still receive $15,000 of that distribution tax- and penalty-free
because it has been more than five tax-years since his first conversion of
$15,000. But the second IRA was converted less than five tax-years ago.
Therefore, the remaining $5,000 of his $20,000 distribution will be
penalized 10% for an early withdrawal because he has not yet met the
five-tax-year rule to tap into the second conversion contribution of
$20,000. And when he takes that sum, he will have only $15,000 of
conversion money left before he begins to take earnings from that Roth
IRA. Your best bet? Keep your paws off your Roth IRA account unless your distribution is qualified and you meet one of the penalty exceptions. It'll make your tax life much easier. The Roth IRA Beneficiaries, Etc.We've discussed many of the common issues that you will be faced with when dealing with the Roth IRA. As our discussion of the Roth IRA winds down, let's turn to some other issues that may be of interest. Not Subject to Minimum Distribution Rules Spouse as Roth IRA Beneficiary Non-Spouse as Roth IRA Beneficiary
But this isn't necessarily a bad thing. Think about it. Any distribution in the year that includes the fifth anniversary of the owner's death would have to be made after the five-tax-year period restrictions on contributions/conversions had expired. Therefore, no part of the distribution would be included in the beneficiary's income. So while the account must be eventually liquidated by the beneficiary, Uncle Sammy has allowed for a method by which, if the beneficiary does the right thing, none of the Roth IRA proceeds will be subject to tax or penalty. Of course, if the beneficiary is greedy and wants to take the Roth IRA distribution immediately after the death of the Roth IRA owner and before five tax-years have passed, there may be taxes to pay. So, in this case, patience is rewarded in the form of tax-free income. On the other hand, if distributions are made over the life expectancy of the beneficiary starting no later than Dec. 31 of the year following the year in which the owner died, it is very possible that some of those distributions would be included in the beneficiary's income. Why? Because the five-tax-year holding period may not have been met. But since distributions are treated as being made out of contributions first, the chances are that most distributions made before the end of the five-tax-year period would be made out of contributions, and would not be subject to tax. But regardless of how the beneficiary decides to take the Roth IRA distributions, and regardless of the taxability of the distributions (if any), none of the distributions would be subject to the 10% early withdrawal penalty. If you go back and read the article on Roth IRA penalties, you'll find that the death of the Roth IRA holder will avoid the 10% penalty on the beneficiary. Example: Shirley converts her traditional IRA to a Roth IRA in 1998. Her conversion tax amounted to $15,000. Shirley included all of this conversion income in her 1998 income, and reported that income in full on her 1998 tax return. Shirley also made $2,000 Roth IRA contributions for 1998 and 1999. In 2002, Shirley passes away. Her Roth IRA beneficiary is her daughter LaVerne. LaVerne can take the entire Roth IRA distribution immediately, but will be subject to some taxes (because she will have taken the distribution before the five-tax-year holding period had expired on the original conversion). But even if LaVerne has taxes to pay on the Roth IRA distribution, there will be no penalties imposed. According to the rules, LaVerne can wait as long as "the end of the year containing the fifth anniversary of the account owner's death" to remove the funds. Since Shirley died in 2002, Laverne must remove the funds from the Roth IRA account no later than Dec. 31, 2007. The five-tax-year holding period would be met in year 2003. So if LaVerne waits until sometime in year 2003 to take the distribution, none of the Roth IRA funds would be included in LaVerne's income. Why? Because the five-tax-year holding period was met, and the account assets were distributed before the required distribution date (Dec. 31, 2007). So, as you can see, even though a non-spouse beneficiary is much more restricted with respect to the inherited Roth IRA account than a spousal beneficiary is, the rules are flexible enough to allow for the beneficiary to dodge taxes and penalties. The Top 10 Roth IRA QuestionsBecause of all of the mystery, intrigue, and curiosity regarding the Roth IRA, we herewith present the 10 questions that seem to be causing the most confusion and generating the greatest number of posts (not to mention excitement!) on our discussion boards. Here they are: 1. I have a company pension plan and contribute as much as I can to a 401(k) plan. Can I still make a full annual contribution to a Roth IRA?
2. I converted my traditional IRA to a Roth IRA back in January. I've just discovered that my adjusted gross income will exceed the $100,000 conversion limitation this year. What should I do?
3. My daughter is 16 years old. Can she make a Roth IRA contribution?
4. My father is 73 years old. Can he convert his traditional IRA to a Roth IRA?
5. I'm retired and drawing Social Security. Can I contribute part of my Social Security benefits to a Roth IRA account?
6. I intend to retire at age 50. When I do, I'll need income. Can I take money from my Roth IRA without paying any taxes or penalties?
7. For income tax purposes, how do I report a conversion and/or an annual contribution to or a withdrawal from a Roth IRA?
8. If I convert my traditional IRA to a Roth IRA, will that conversion income increase my AGI for the current year?
9. If I have a large tax balance due next April because of my Roth IRA conversion, will I be able to avoid the underpayment penalties?
10. Should I convert my traditional IRA to a Roth IRA?
And finally, since we are Fools, and we're all about giving, here is your free, bonus Q&A: Q: I've heard from a friend that the Roth IRA AGI limitation is $100,000. I've heard from other friends that the actual AGI limitation is much greater. Which is it?
All About IRAs - For First-Time Home BuyersIt's not often that you can take money from your traditional IRA or from your earnings in a Roth IRA before age 59 1/2 and avoid the dreaded 10% early withdrawal penalty. But, surprisingly enough, this is one of the tax benefits enacted as part of the 1997 Taxpayer Relief Act to help people become homeowners. Now the law allows individuals to receive distributions from their traditional IRAs to pay up to $10,000 of first-time homebuyer expenses without incurring the 10% early withdrawal penalty that usually applies to withdrawals from a traditional IRA before age 59 1/2. But, even though the penalty is waived, you will still be required to pay taxes (as applicable) on the traditional IRA withdrawal itself. The rules for taking a distribution from a Roth IRA to finance a first-time home purchase are slightly different than those for a traditional IRA. Remember that a withdrawal taken from a Roth IRA for the purchase of a first home is considered a qualified distribution after the account has been open for five tax-years. As such, any distribution taken from a Roth for that purpose and under those conditions will be both income tax- and penalty-free. But also remember that under the Roth distribution ordering rules, the first money out will be annual contribution money, which is never taxed or penalized. Next out would be conversion money, and that also would not be taxed or penalized provided it has been in the Roth for five tax-years. And last out would be earnings. Therefore, because of these distribution rules, that means the only money taken from a Roth IRA that might pose a problem would be either earnings or conversion money that has been in the Roth for less than five tax-years. What happens if you take earnings or conversion money before the necessary five tax-years have run? Well, in the case of earnings, you still meet the exception to avoid the early withdrawal penalty, but you don't meet the criteria for a tax-free withdrawal from a Roth IRA. Accordingly, just as you would for a withdrawal from a traditional IRA, you must pay an ordinary income tax on the distribution. When it comes to taking a withdrawal of conversion money early, you won't owe income tax because you already paid that during the original conversion. Ordinarily, though, those under age 59 would owe the 10% early withdrawal penalty for taking the money before five tax-years had passed since the conversion. But a distribution for a first home purchase is an authorized exception to the early withdrawal penalty on IRA distributions. Therefore, conversion money, even when taken early, may be used for this purpose free of penalty. In an odd twist of government logic (is there really such a thing?), you should know that a "first-time homebuyer" doesn't really have to be a first-time homebuyer. That's because the law defines "first-time homebuyer" as someone who has not owned a home for two years. So in addition to benefiting "first-time" homebuyers, the law also helps "not-recent" homebuyers. And, in yet another twist of government logic, you can take advantage of the provision even if you are not the first-time homebuyer, since the first-time homebuyer can be the traditional or Roth IRA owner, his or her spouse, or any of their children, grandchildren, or ancestors. So maybe this provision should really be called, "Penalty-Free Withdrawal for Not-So-Recent Homebuyers and/or Relatives of an IRA Owner." You be the judge. Anyway, the $10,000 limit is a lifetime limitation on the amount of withdrawals in total that can be pulled out of all your traditional or Roth IRAs penalty free under the first-time homebuyer provision. Don't think that you'll get this relief each and every time you want to buy another home or each and every time you use a different IRA to make such a withdrawal. Once you use up your $10,000, you're done. And while the law isn't clear, it seems permissible that, for example, a husband and wife helping one of their children scrape together a down payment could each withdraw up to $10,000 from their respective traditional or Roth IRAs without incurring any penalty for early withdrawal. Also note that any IRA funds distributed to you must be used to pay
qualified acquisition costs before the close of the 120th day after the
day you received the distribution -- so this isn't a completely
"open-ended" deal. You need to plan your purchase and your distribution
carefully. Qualified acquisition costs include the costs of buying,
building, or rebuilding a home and any usual or reasonable
settlement, financing, or other closing costs. So, the distribution must
be related to the purchase of the property and can't be used for other
home-related expenses such as furnishings or general home repairs or
maintenance. How To Open an IRAIt's really quite simple to open an IRA account. Here are a couple of suggestions to help get you started. Step 1: Find a Discount Broker
The reason for such a parsimonious attitude toward your IRA account is that your contributions are limited to $2,000 a year per person. An extra $50 a year in transaction fees will, over time, reduce your account balance by tens of thousands of dollars. In other words, it pays to shop around. In retirement those fees could mean the difference between serving festive drinks on your beachfront property in Tahiti, or sipping generic beer at your timeshare in Toledo. For those eager to start saving for their slice of retirement paradise right now, we've put together a table that compares brokers in our Discount Brokerage Center. Compare their fees and services. And if you find a broker that looks good to you, go ahead and open an account or get more information! Step 2: Open and Fund Your Account By the way, if you are rolling over a 401(k) or other retirement plan to an IRA, your new broker will once again be happy (really, really happy) to assist you in transferring your retirement plan funds to your new account. Many folks desire to transfer stock shares they already own into their new IRA. Bear in mind that by law shares may be transferred to an IRA only when the transfer is from an existing IRA or from an employer's qualified retirement plan. Shares may NOT be transferred from an ordinary brokerage account into an IRA. Step 3: Invest It! When you decide what you're going to buy, you'll need to allow for any commissions. Let's say you're investing $2,000 and your broker charges $12 a trade. You decide to buy shares in a growth stock that's priced at $20 per share. Sure, you'd love to buy 100 shares and hit that $2,000 mark right on the nose. But you can't. You have to buy 99 shares, which comes to $1,980. That leaves you $20 ($2,000 - $1,980) out of which you'll pay your commission. Then you'll have $8 left in cash that you can include in your next trade. IRA GlossaryAGI (adjusted gross income) Annual contribution limits Contributions Distributions, or Withdrawals Earnings Education IRA (EIRA) Employer and Employee Association Trust Account, or Group IRA Individual Retirement Account Individual Retirement Annuity Inherited IRA Qualified distribution (Roth IRA)
However, even if one of the qualifications above is met, the distribution is STILL not qualified if it is made within a five tax-year period. Rollover (Conduit) IRA Roth IRA
SEP-IRA (Simplified Employee Pension) SIMPLE-IRA (Savings Incentive Match Plan for Employees IRA) A traditional IRA set up by a small employer for a firm's employees. In 2001, an employee may contribute up to $6,500 per year to these IRAs. This contribution limit will increase each year through 2005, when it will reach $10,000. In 2006 and later years, the allowable contribution will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed. The employer sponsoring the SIMPLE will also make a matching contribution based on a percentage of the employee's pay. Between the employer and the employee, in 2001 up to $13,000 may be contributed annually to the participant's account. See our Retirement Plan Primer for a more complete discussion of SIMPLEs. Spousal IRA Traditional, or Regular, IRA
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