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What Is a Roth IRA: Full Guide to Getting Started

A Roth IRA is a type of Individual Retirement Account that has the unique feature of being funded with after-tax dollars, which means you contribute money that’s already been taxed. This differs from other traditional types of IRAs, which are tax-deferred. Contributions to the account are not tax deductible. However, after the funds have been in the account for five years, withdrawal of earnings can be made without incurring taxes or penalties. The best part about these accounts is that there are no income limits on who can fund them, unlike other retirement plans such as 401(k)s and Traditional IRAs.

Who Should Get a Roth IRA?

The main benefit of funding a Roth IRA is that your contributions will never be taxed, and since the contribution limits are higher than those of other IRAs – $5,500 or $6,500 per year – it’s a great way to invest more money for retirement. If you’re young and believe your income will go up as you get older (and therefore end up in a higher tax bracket), then it makes sense to pay taxes now on money that will be worth more when you withdraw it later.

Roth IRA Contribution Limits

The IRS regulates how much can be contributed every year based on your age and whether or not you have a retirement account with an employer:

Let’s say we chose to contribute $5,000 this year to our Roth IRA account. When April 15 rolls around, the IRS will take $5,000 out of our bank account to pay any taxes we owe. But because Roth IRAs are funded with after-tax money, you won’t get that money back in your bank account unless you withdraw it or rollover into another account (Roth IRA accounts must be held for five years before they can be rolled over).

How to Open a Roth IRA Account

Setting up an account is easy and usually requires just filling out some paperwork about yourself and your income. After that, all you have to do is choose which investments you want your money to go toward from a list of available options from your brokerage or mutual fund company. You can even open two or more Roth IRA accounts each year if you want.

Paying Taxes on Roth IRA Withdrawals

One of the most attractive features that separate Roth IRAs from other retirement accounts is their tax-free withdrawal policy. This means that after your money has been in the account for at least five years, you can withdraw up to $10,000 per year, or $20,000 per year if you are married and filing jointly with your spouse. As long as it’s been in there longer than five years, all withdrawals are tax free. So what happens when you want to withdraw more than $10,000? Well if you’re withdrawing amounts between $10,000 and $100,000 then a flat 5 percent fee will apply (you don’t have to pay this fee if you’re over age 59½ or retired).

For example, let’s say you have a Roth IRA account that holds $50,000 and has been open for 10 years. Right now the market is down and you need to withdraw $15,000 from your account to cover expenses. In this case, you will be charged a 5 percent tax on the amount between $10,000 and $15,000 – which is $500 – so in total you would receive a withdrawal of $14,500 ($15,000 – $500 =$14,500) . You can avoid paying these fees if your Roth IRA accounts are larger than these amounts:

If your Roth IRA balance is less than five times the annual limit on additions to an IRA, then you can avoid the 5 percent tax. For example, if your Roth IRA holds $25,000 and you want to withdraw $15,000 from it, you won’t have to pay a fee because the account is under five times the allowed add-on amount ($10,000 x 5 = 50,000). In this case, you’d receive a withdrawal of $15,000.

If your Roth IRA balance exceeds five times the annual limit on additions to an IRA – which would be a balance of $125,000 in our example above – then a flat 25 percent fee will apply to all withdrawals over that amount. If we do the math for this scenario: Maximum contribution : $10,000 per year Addition allowed in a single year : $50,000 Five times the annual limit on additions in this case is equal to $250,000. This means that if you have an account balance of any amount over $250,000 then you would be charged 25 percent when withdrawing more than five times the annual limit on additions.

When it comes to Roth IRA withdrawal rules, one thing you should always keep in mind is that there are penalties for making contributions once you hit age 70½. You will need to either wait until after 70½ or amend your plan with your company’s administrator to avoid being penalized . If amendments aren’t accepted, then the only way to avoid being taxed on Roth IRA withdrawals after 70½ is to convert your account into a Roth IRA when you’re younger than 70½.

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Roth IRA Contribution Limits

The total annual contribution limit in 2010 for all IRAs (traditional or Roth) was $5,000; beginning in 2011 the maximum amount increased to $5,500 per year (the total contribution limit is indexed to inflation). Anyone age 50 and older can contribute up to an additional $1,000 per year . If you have more than one Roth IRA account, then the combined limits are still only $5,500-$6,500 per year depending on your age.

These limits include both deductible contributions that you make to traditional IRAs and contributions made through rollovers into Roth IRAs. If you’re married, then your spouse can contribute to a Roth IRA account even if you don’t because it’s an individual retirement plan. The amount that each person can contribute is based on their salary and will show up on their Form 1040 in the “Adjusted Gross Income” (AGI) section.

Example: Mr. Smith makes $80,000 per year, while his wife does not work outside of the home. Mrs. Smith has no income but takes care of the couple’s two children under age 10; she also takes care of her elderly parents who live with them; this adds up to her making about $20,000 per year when taking into consideration everything that she does the family (all non-monetary contributions). Mr. Smith can contribute up to $5,500 in 2010 ($80,000 – $75,000) x .17 (17% of his income is not taxed by the government for use with Roth IRA purposes) = $5,500. Mrs. Smith can also contribute up to $5,500 even though she doesn’t work outside of the home because it’s an individual retirement plan and based on her salary that is valued at about $20,000 per year when all factors are taken into consideration.

Another thing you should remember about Roth IRA contribution limits: If you’re married and filing a joint tax return and one person contributes $4,000 to a Roth IRA while the other contributes nothing (or doesn’t contribute the maximum $5,500), then the non-contributing spouse is considered to have made a contribution of $4,000 in that tax year even if they didn’t actually contribute anything. This is referred to as the spousal IRA .

If you and your spouse both earn salaries and want to contribute to Roth IRAs in 2010, but one salary is much higher than the other so it makes more sense for only one person to contribute to a Roth IRA instead of wasting money because their income disqualifies them from contributing to a Roth account , then this would be beneficial. For example, let’s say Mr. Smith makes $120,000 per year while his wife doesn’t work outside of the home; he would be considered responsible for contributing 50% of the Roth IRA contribution that they make between them (since it’s an individual plan). Therefore, Mrs. Smith’s maximum allowable contribution would be $2,500 instead of $5,500 because Mr. Smith is making over 70% of their combined income (120,000 / (120,000 + 0)).

Example: You and your spouse make a total of $80,000 but you earn $50,000 while your spouse earns $30,000; you can each contribute up to $5,500 to your own separate accounts even though family income is only about 30%. If you’re married filing jointly with someone who has no earned income then you can contribute up to 100% of your salary or up to $11,000 (whichever is less) even if the total amount you and your spouse make is over $167,000.

Contribution Limits for Roth vs Traditional IRAs

The distinction between whether to contribute to a Roth IRA or traditional IRA depends on how much money you’re earning because of the tax implications when withdrawing from these accounts in retirement . If you’re making more than $116,000 per year as a single person or $169,000 per year as a married couple filing jointly , then it makes sense to contribute up to the maximum allowed in either account because you’ll be taxed at this level now instead of later when withdrawing from your retirement account. This will ensure that your contributions grow tax-free and you’ll be taxed at the lowest possible rate when taking money out of your IRA in retirement. However, if you’re making less than $95,000 per year as a single person or $150,000 per year as a married couple filing jointly , then you should contribute to a Roth because it makes more sense for your income levels .

Another thing you need to know about whether to contribute to a traditional IRA or Roth IRA is that if one spouse has an employer-sponsored plan (like a 401(k) ) and the other doesn’t, then it’s usually better for the spouse who doesn’t have access to such a plan (in most cases this would be the wife) to make contributions to their own IRA and then convert it to their spouse’s Roth IRA, because this will allow them to contribute up to $11,000 (in 2009) to their own account before the income limits prevent them from doing so. You should never make more than $100,000 per year as a single person or $160,000 per year as a married couple filing jointly if you plan on converting your traditional IRA into another Roth IRA; otherwise you’ll be subjected to an early withdrawal penalty . This is something else that you need take into consideration when deciding which type of IRA is best for you.

If you’re not working then the above rules don’t apply and anyone can contribute up to $5,500 to a Roth IRA of how much money they earn or making.

For more about IRA contribution rules, keep reading this article.

What is the 2010 Roth IRA Conversion Deadline?

If you want to convert a traditional IRA into a Roth IRA but didn’t do it in 2009 because the income limits prevented you from doing so, then you still have another day left to make these conversions for 2010 without paying an early withdrawal penalty or any taxes on the amount of money that you shift over from your traditional IRA into your Roth IRA. This deadline is not January 31st like most other deadlines are, but rather April 15th , which means that if you file your federal income tax return prior to April 15th then you can still contribute to your account before the deadline expires . You can even wait until April 17th and still make a contribution for 2010. Keep in mind that this is only true for Roth IRA conversions; you can’t do this with any other type of traditional IRA contribution (even if you file your federal income tax return early you can’t make a conversion after the deadline has passed).

Roth IRA Conversions: Questions & Answers

You might find yourself wondering about how to actually go about making a Roth IRA conversion if you haven’t done one before. It’s not a difficult process but it does take a few days to complete, so don’t expect to be able to contribute money to your account by April 15th and have it show up in there on the same day. Once you’ve contributed the maximum amount of money that you are allowed to contribute based on your income level , make an appointment with a bank or brokerage firm where you plan on opening your Roth IRA account and ask them how best to go about having your traditional IRA funds converted over to their institution.

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You’ll first have to open up a new Roth IRA account at the same bank or brokerage firm that you’re visiting, then have the company that manages the other IRA send them a check for this amount of money along with all relevant paperwork including any forms that need to be filled out, which should include Form 8606 . Once all of this is done, there might be some waiting involved before your money finally shows up in the account because these things take time . According to Ed Slott, a CPA and IRA expert, “the company that processes the conversion says it will take two to three weeks for all of this paperwork to come through from the custodian that holds the rollover funds.” Do not expect this process to be completed before April 15th.

Once your money does finally show up in your Roth IRA account you’ll have to report any earnings from those funds on Form 8606 , which is nothing more than another tax form but with very detailed instructions . You should file this form along with your regular income tax return (it can go on either one of them). Keep in mind that if you’re only making conversions after April 15th 2010 then you won’t need to worry about taxes or an early withdrawal penalty at all.

One very important point to mention is that the money you will be converting over from your traditional IRA and paying taxes on has already been taxed , so in most cases it would be a good idea to leave this money alone instead of withdrawing it for non-IRA related purposes after the conversion takes place. Since you’ve already paid tax on that amount of money, withdrawing it could draw some serious penalties including the loss of any deductions or credits that may have applied to those funds.

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