| Topic - Roth IRAs: Just Say No to Future Taxes | Education Center |
Unlike a regular IRA, where funds grow on a tax-deferred basis, funds you deposit into a Roth IRA grow on a tax-free basis in the account until you withdraw them. When you eventually retire (or meet certain other criteria) and withdraw funds from your Roth IRA, you will not have to pay any taxes on the earnings you've accumulated over the years. (Remember, when you withdraw money from a regular IRA, you have to pay taxes on the withdrawal as regular income.)
The reason that your withdrawals are tax-free is that the initial contributions you make to a Roth IRA are non-deductible -- you don't get a break on your tax bill when you put money into a Roth IRA as you do when you contribute to a regular IRA.
If your 2000 MAGI (modified adjusted gross income) is more than $160,000 (for a married couple, filing jointly) or $110,000 (for a single individual), you can stop reading right now -- you're not eligible to contribute to a Roth IRA this year.
If your MAGI is $150,000 or less (married, filing jointly) or $95,000 or less (filing singly), then you can contribute $2,000 per spouse to a Roth IRA. You can contribute to a Roth IRA even if you or your spouse is covered by a pension plan or by a company retirement plan like a 401(k).
If your AGI is between $150,001 and $160,000 (married, filing jointly) or between $95,001 and $110,000 (filing singly), the amount you can contribute is gradually phased out.
There are a lot of special rules that govern when you can take money out of a Roth IRA. Every IRA is made up of two types of funds: contributions, the money you put into the account, and earnings, the amount of any investment gains that your contributions have made while in the account (sometimes known as accumulated earnings). Funds that you withdraw from the IRA are known as distributions.
You can take out contributions at any time from a Roth IRA without penalty and without any tax liability. Not that you'd want to take out those contributions; after all, it's the power of compounding that can really build up your portfolio over a long period of time. But, it's nice to know that you have access to some cash in case of a big emergency.
After a five year period, you can withdraw the earnings that have accumulated in your account without taxes or penalty, but only for the following very specific "life changes":
One difference between a Roth IRA and a traditional IRA is that upon your death, your heirs would receive your Roth IRA proceeds entirely free from federal income taxes, whereas, in a regular IRA, your heirs would be liable for taxes on the total amount of your account.
Any funds taken out of your IRA for the above reasons and after the five-year period are known as a qualified distribution.
If you withdraw earnings for any reason other than those listed above, then you'll pay Federal taxes at your regular income tax rate and a 10 percent premature withdrawal penalty. This is called an unqualified distribution.
You can avoid the premature withdrawal penalty in some instances. Roth IRAs have some other provisions that give you a break on the penalty in the case of some other "life changes." You are exempted from the penalty, but not from the taxes, if you take out earnings from the account for the following reasons:
Another point is worth mentioning here: Any withdrawals you make are treated as coming first from non-taxable contributions. You can't choose whether to withdraw earnings or contributions -- you must take out the money you put in first, and then take out the earnings. While this isn't a problem in most cases (since your contributions can be accessed without penalties and taxes), it may make a difference when planning withdrawals in some circumstances.
One more thing. States don't always follow changes in federal law, so there may be state taxes on accumulated earnings that are withdrawn from a Roth IRA, whether or not they are free from federal taxes. You'll need to check with the department of taxation in your state to see how they handle these distributions.
When you make your 1999 contribution to a Roth IRA, you should take care to establish a new and separate account instead of adding the funds into a "rollover Roth IRA" that you might have already created. This will preserve the more lenient accessibility to the funds that you have contributed to the new Roth IRA, compared to the proposed five-year restrictions on the rollover Roth IRA. If you commingle your new Roth contributions in an account that holds your rollover distribution, your new deposits will be subject to the more stringent rules of a conversion Roth IRA.
The bottom line is that Roth IRAs offer a totally tax-free way to save for retirement. In addition, in many instances you can have access to the money in your account before retirement with no penalty and little or no tax liability. With the Roth IRA, Uncle Sam has given Americans a nice break and an important new retirement planning tool.