Since it’s inception on January 2, 1998 the Roth IRA (Individual Retirement Arrangement) has become one of the most popular investment opportunities for those who want to start building a nest egg for retirement. It’s fairly straightforward and easy to understand but, since it’s your retirement account we’re talking about and you want to make sure there’s plenty of it to go around when you’re ready for it, then you need to make sure you understand the Roth IRA Rules before you go aimlessly investing your money.
Tax Exempt or Tax Deferred?
One of the main differences between a Roth IRA and a standard IRA is the way the taxes are handled. An investment to a standard IRA is tax deferred meaning that you deduct the amount you’re contributing from your total annual income before your pay your taxes. The benefit of this type of IRA is that you’ll lower your annual tax bill each year you contribute. However, you’ll be taxed when you start withdrawing.
Your contribution to a Roth IRA is tax exempt meaning it does not effect your adjusted gross income. However, when you withdraw it at retirement age you don’t have to pay any more taxes. The benefit with the Roth IRA is that you won’t have to worry about paying taxes on your money when it comes time for withdrawal. However, if tax rates have dropped significantly since you first started saving, you may have lost money over the years.
Other Roth IRA Rules and Regulations
Must be income – Another one of the most important Roth IRA rules is that all contributions must come from your taxable income. Meaning you can not use inheritance money to fund your Roth IRA. Since you won’t be paying taxes on your money when you withdraw it, Uncle Sam wants to make sure you paid taxes on it before you deposited it. This income can come from wages, tips, bonuses, earnings on investments, etc., but it must be taxable income.
It’s also important to note here that you can have more than one Roth IRA. However, you need to be careful. Should your combined contributions exceed your income for the year the IRS will get suspicious. They’re very serious about using taxable income only for your contributions. Keep in mind too that, after you retire, if you have no taxable income, you’ll no longer be able to contribute to your Roth.
Mandatory withdrawal – With a standard IRA you must begin taking payouts when you reach the age of 70 ½. Roth IRA rules state that since the government has already taxed your contributions, you have no penalty for withdrawal, you have no mandatory withdrawal age, and you never even have to withdraw the money if you don’t want to.
Contribution limits – Contributions to any type of IRA are currently limited to $5,000 per year into each account. You have from January 1 of one year to April 15 of the next to make contributions to your account. Keep in mind, if you’re adding to your account between January and April you’ll want to let your accountant know in which year you want the contribution to fall.
Earnings limits – One drawback on a Roth IRA is that your income cannot exceed $105,000 annually. If contributing to a joint account your combined incomes can’t exceed $166,000. However, there are guidelines established, called phased out eligibility, that allow for contributions on incomes of up to $120,000 and $176,000 respectively and your accountant will have more details.
Age restrictions – There are no age restrictions on a Roth IRA which makes it very attractive for young people to get a head start on saving for their retirement.
Withdrawal penalties – One of the most often overlooked Roth IRA rules states that if you withdraw money before the age of 59 you’ll incur a 10% early withdrawal penalty. On top of that you’re going to have to pay the taxes on the amount of money you withdraw. Depending on the size of the distribution you take when you add up the taxes and the early withdrawal penalty you could be looking at a substantial chunk of money.
All things considered the Roth IRA is generally the most often recommended way to go for setting up a retirement account. If you’re in doubt, and your income falls below $105,000 a year then you’re generally safe going with the Roth. So stop researching, stop hesitating, just do it! When you reach retirement age you’ll be glad you did.