ROTH IRAS: HOW THEY WORK AND HOW TO USE THEM

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Roth IRAs: How They Work and How To Use Them

Roth IRAs differ from other tax-favored retirement plans, including other IRAs (called "traditional IRAs"), in that they promise complete tax exemption on distribution. There are other important differences as well, and many qualifications about their use. This Financial Guide shows how they work, how they compare with other retirement devices--and why YOU might want one, or more.

With most tax-favored retirement plans, the contribution to (i.e., investment in) the plan is deductible, the investment compounds tax-free until distributed, and distributions are taxable as received. There are variations from this pattern, as with 401(k)s where the exemption for salary diverted to a 401(k) takes the place of a deduction and for after-tax investments where invested capital is tax-free when distributed.

With a Roth IRA, there`s never an up-front deduction for contributions. Funds contributed compound tax-free until distributed (standard for all tax-favored plans) and distributions are completely exempt from income tax.

How Contributions Are Treated

The 2017 annual contribution limit to a Roth IRA is $5,500 (same as 2016). An additional "catch-up" contribution of $1,000 (same as 2016) is allowed for people age 50 or over bringing the contribution total to $6,500 for certain taxpayers. To make the full contribution, you must earn at least $5,500 in 2017 from personal services and have income (modified adjusted gross income or MAGI) below $118,000 if single or $186,000 on a joint return in 2017. The $5,500 limit in 2017 phases out on incomes between $118,000 and $133,000 (single filers) and $186,000 and $196,000 (joint filers). Also, the $5,500 limit is reduced for contributions to traditional IRAs though not SEP or SIMPLE IRAs.

You can contribute to a Roth IRA for your spouse, subject to the income limits above. So assuming earnings (your own or combined with your spouse) of at least $11,000, up to $11,000 ($5,500 each) can go into the couple`s Roth IRAs. As with traditional IRAs, there`s a 6 percent penalty on excess contributions. The rule continues that the dollar limits are reduced by contributions to traditional IRAs.

How Withdrawals Are Treated

You may withdraw money from a Roth IRA at any time; however, taxes and penalty could apply depending on timing of contributions and withdrawals.

Qualified Distributions

Since all your investments in a Roth IRA are after-tax, your withdrawals, whenever you make them, are often tax-free. But the best kind of withdrawal, which allows earnings, as well as contributions and conversion, amounts to come out completely tax-free, are qualified distributions. These are withdrawals meeting the following conditions:

  1. At least, five years have elapsed since the first year a Roth IRA contribution was made or, in the case of a conversion since the conversion occurred and
  2. At least one of these additional conditions is met:

Note: A distribution used to buy, build or rebuild a first home must be used to pay qualified costs for the main home of a first-time home buyer who is either yourself, your spouse or you or your spouse`s child, grandchild, parent or another ancestor.

Non-Qualified Distributions

To discourage the use of pension funds for purposes other than normal retirement, the law imposes an additional 10 percent tax on certain early distributions from Roth IRAs unless an exception applies. Generally, early distributions are those you receive from an IRA before reaching age 59 1/2.

Exceptions. You may not have to pay the 10 percent additional tax in the following situations:

Part of any distribution that is not a qualified distribution may be taxable as ordinary income and subject to the additional 10 percent tax on early distributions. Distributions of conversion contributions within a 5-year period following a conversion may be subject to the 10 percent early distribution tax, even if the contributions have been included as income in an earlier year.

Ordering Rules for Distributions

If you receive a distribution from your Roth IRA, that is not a qualified distribution, part of it may be taxable. There is a set order in which contributions (including conversion contributions) and earnings are considered to be distributed from your Roth IRA. Order the distributions as follows.

  1. Regular contributions.
  2. Conversion contributions, on a first-in-first-out basis (generally, total conversions from the earliest year first). See Aggregation (grouping and adding) rules, later. Take these conversion contributions into account as follows:
  3. Earnings on contributions.

Disregard rollover contributions from other Roth IRAs for this purpose.

Aggregation (grouping and adding) rules.

Determine the taxable amounts distributed (withdrawn), distributions, and contributions by grouping and adding them together as follows.

Add any recharacterized contributions that end up in a Roth IRA to the appropriate contribution group for the year that the original contribution would have been taken into account if it had been made directly to the Roth IRA.

Disregard any recharacterized contribution that ends up in an IRA other than a Roth IRA for the purpose of grouping (aggregating) both contributions and distributions. Also, disregard any amount withdrawn to correct an excess contribution (including the earnings withdrawn) for this purpose.

Example: On October 15, 2007, Justin converted all $80,000 in his traditional IRA to his Roth IRA. His Forms 8606 from prior years show that $20,000 of the amount converted is his basis. Justin included $60,000 ($80,000 - $20,000) in his gross income. On February 23, 2007, Justin makes a regular contribution of $4,000 to a Roth IRA. On November 7, 2007, at age 60, Justin takes a $7,000 distribution from his Roth IRA.

Distributions after Owner`s Death

Qualified distributions after the owner`s death are tax-free to heirs. Nonqualified distributions after death, which are distributions where the 5-year holding period wasn`t met, are taxable income to heirs as they would be to the owner (the earnings are taxed), except there`s no penalty tax on early withdrawal. However, an owner`s surviving spouse can convert an inherited Roth IRA into his or her own Roth IRA. This way, distribution can be postponed, so that nonqualified amounts can become qualified, and the tax shelter prolonged.

Roth IRA assets left at death are subject to federal estate tax, just as traditional IRA assets are.

Converting from a Traditional IRA or Other Eligible Retirement Plan to a Roth IRA

The conversion of your traditional IRA to a Roth IRA was the feature that caused most excitement about Roth IRAs. Conversion means that what would be a taxable traditional IRA distribution can be made into a tax-exempt Roth IRA distribution. Starting in 2008, further conversion or rollover opportunities from other eligible retirement plans were made available to taxpayers.

Conversion Methods

You can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used.

You can convert amounts from a traditional IRA to a Roth IRA in any of the following three ways.

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