In general, contributions to a Roth IRA are made using your after-tax dollars. Thus, there is no upfront tax savings to you, which may seem a bad deal on your current year’s finances.
However, the key advantage of this type of IRA is if you start receiving distribution come retirement time, you will not have to pay taxes on that. In addition, you can make an early withdrawal of the original contribution at anytime and there are no taxes and penalties imposed, which is not the case with a traditional IRA or any other tax deductible retirement plans.
A Roth IRA is a great option than a traditional IRA if you anticipate to pay a higher income when you retire. This means that either you have a huge retirement plan provided by your employer, or you are expecting other non-retirement income as well such as residual income from a business, lottery winnings or other investments.
In addition, kids who are in the lower bracket and are earning at or below the standard deduction for the tax year may be able to take advantage of a double tax benefit: contributions and distributions are both tax-free!
Below are the seven quick facts when making contributions to your Roth IRA:
1. You must have earned income to make a contribution
For both the traditional and Roth IRA, you can only make contributions if you have compensation or earned income. The IRS defines compensation as money you have earned from working. Examples are wages, salaries, commissions, self-employment income, alimony, and non-taxable combat pay.
Income received from pension, annuity, deferred compensation, rental income, dividend income, interest income, income from partnership for which you do not provided services that are material income producing income, and any amount you exclude from income (except for the non-taxable combat pay) are not considered compensation.
2.You can contribute towards your spouse’s Roth IRA even if spouse does not work – Spousal IRA
The only exception to fact #1 is if you are married and your spouse is the only one earning a living. In this case, you can still contribute for as long as your spouse has earned income AND you and your spouse are filing a joint tax return.
3. Generally, the maximum contribution to a Roth IRA is $5,000 in 2011
There is a limit on how much you can contribute to your Roth IRA. In general, your contribution is limited to $5,000 for the tax year. The limit applies annually per individual and not per IRA account for those who have more than IRA accounts set-up with multiple financial institutions. For example, you may have three IRA accounts established from your bank or mutual fund companies but you cannot contribute $5,000 on each account in the same year. Thus, $5,000 must be allocated into the three Roth IRA accounts.
However, the following are the exceptions to the $5,000 maximum limit:
- Catch-up Rule for 50 years or older – $6,000 maximum – If you are 50 years or older, your maximum contribution is increased to $6,000. This rule is made to allow late savers who did not save enough early put in additional money on their retirement funds.
- Maximum Limited to Your Earned Income – If your earned income is less than $5,000, your maximum contribution is limited to your earned income.Â Â As an example, you recently just graduated from college but you did not start working until the last week of November. For that year, you are a student and worked part-time earning just $3,000 for the year. Since your income from work is only $3,000, this is the maximum amount that you can contribute to your IRA.
- Maximum Limits Applies to Both Roth & Traditional IRA – The maximum contribution that can be made for both IRAs is only $5,000 if you are contributing to both accounts in the same tax year. This means that if you have already contributed $2,000 in your traditional IRA, you can only contribute $3,000 to your Roth IRA. You cannot contribute $5,000 to both accounts in the same tax year.
4. Your Roth IRA contributions will be phased out (or reduced) if your income exceeds the IRS income limits.
- For married joint filers and qualified widower, the IRA contribution is phased out if your modified adjusted gross income (MAGI) is between $169,000 and $179,000 in tax year 2011. You can no longer contribute to your Roth IRA if your MAGI is more than $179,000.
- For married separate filers not living with the spouse at anytime in 2011, single, and head of household filers, the Roth IRA contribution is reduced (or phased out) if your MAGI is between $107,000 and $122,000 for tax year 2011. You can no longer contribute if your MAGI is more than $122,000.
- For married separate filers but living with spouse at anytime in 2011, the Roth IRA contribution is reduced if your MAGI is between $0 and $10,000. No contributions are allowed if MAGI is more than $10,000.
5. If you contribute more than the maximum amount, you have to pay an excise tax.
If you contribute more than the limit, you have to pay a 6% excise tax for each year on the amounts that remain in your account for the tax year. However, if you have excess amount in the current year and you withdrew the money before the tax deadline, you do not have to pay the 6% excise tax.
6. You can make contributions during the year up to the tax year deadline.
You can make a contribution during the year towards your traditional IRA and you have until the tax year deadline to do so. For example, for tax year 2011, you already contributed $1,000 in March 2011, $3,000 in July 2011. You can still make a $1,000 contribution (to complete the $5,000 maximum) up to the 2011 tax return deadline (April 2012).
7. Unlike the traditional IRA, Â you can still make contributions even if are already 70 1/2 years or older.
Once you reach the age of 70 1/2 years, you can still contribute towards your Roth IRA accounts. There is also no mandatory minimum distribution when you reach this age. You can keep the money there for as long as you want.
Source: IRS – Publication 590
Robert @ The College Investor says
Those are useful tips. Thanks for compiling them.
I like your ‘nutshell’ approach to this topic! I recently signed up for spousal ira doubling my tax-deferred investment space!
Excellent summary on the highlights and advantages of the Roth IRA. They’re an excellent choice for anyone who isn’t covered by a retirement plan at work, doesn’t have an employer match on a 401k, or is in a situation where money contributed to a retirement plan may be needed well before retirement. Not that withdrawing retirement money should ever be encouraged, but the fact that Roth IRA contributions can be withdrawn tax- and penalty-free is a huge advantage in a job market thats a lot less stable than it used to be. And the tax- and penalty-free withdrawals after age 59.5 won’t feel to bad either!