Roth IRAs: What Everyone Ought to Know Though it has been part of the retirement investing landscape for more than a decade now, many people still don't really understand the Roth IRA, or what it can do for them.

The key feature of a Roth is this: Your retirement dollars grow and can be withdrawn tax free, as long as you abide by the rules. You can only deposit after-tax money into a Roth, and generally you can't touch your cash without penalty until you are 59½ years old. Know too, that you have to wait five years before withdrawing money for any purpose. "There are exceptions, but the rules can be complex," says Scott Cramer, president of financial advising firm Cramer & Rauchegger. "Ask your financial adviser."

Beyond those basics, there are all sorts of myths and misunderstandings about this tax-advantaged savings vehicle, some of which stem from the fact that there is also a Traditional IRA, with its own set of rules and requirements.

So to sort fact from fiction, here's what you need to know.

Conversion Confusion

When you convert a Traditional IRA to a Roth IRA, and use a distribution from the Traditional IRA to pay the income taxes due, that money used to pay the taxes will count as ordinary taxable income for you. If you're younger than 59½, the distribution used to pay the taxes may be subject to a 10% excise tax for premature withdrawal, explains Mickey Cargile, founder and managing partner of WNB Private Client Services and Cargile Investments.

Also, you'll have to take your Required Minimum Distribution (RMD) in the year you convert.

"Some clients think that if they convert to a Roth, they can avoid the distribution for that year," says Jonathan Blumenthal, a certified financial planner and senior vice president with Peak Capital Investment Services. Then too, in the year you convert, the additional income will typically count in higher income taxes against your Social Security benefits and increase your Medicare part B premiums just for the year you convert, he adds.

If your Traditional IRA is subject to an RMD, when you convert it to a Roth IRA, you must take your annual RMD before the conversion. The RMD is not eligible for conversion. Failure to follow this rule will result in a 50% excise tax on the RMD amount, plus penalties for over-contribution to the Roth, says Cargile.

Some people also don't realize that conversions can be broken into multiple pieces, or done gradually over time. Plus, they can be reversed for a period of time, that can reach almost two years in some cases, according to Paul Jacobs, a certified financial planner with Palisade Hudson Financial Group.

The decision of whether or not to convert a Traditional IRA to a Roth IRA is not always a simple one -- much depends on your tax bracket status. Many people in higher tax brackets (or whose tax brackets are going up) would generally want to convert a Traditional IRA to a Roth IRA. By contrast, those whose tax brackets may be decreasing might benefit from keeping their savings in a traditional account, says John Liu, CEO of online brokerage Firstrade.

An Overlooked Benefit

An often-overlooked benefit of the Roth IRA is that the tax free distributions from the account don't count against income in the calculation of taxable Social Security benefits. Social Security recipients in the right income level may benefit from reduced taxes on Social Security benefits by converting their Traditional IRAs -- which are subject to taxable RMDs -- to Roth IRAs that don't require distributions and do have qualified tax-free distributions, says Cargile.

Don't Wait to Roll Over Your 401(k)


After-tax dollars in your 401(k) plan can be rolled directly to a Roth IRA with no tax consequences. "It's a mistake to not roll over those after-tax dollars from your 401(k) plan into a Roth immediately. Dollars growing tax deferred could be growing tax free," says Blumenthal.

Rate of Return Isn't Set in Stone

Many people believe that you get a specified rate of return from a Roth IRA and try to find the best rates out there. This is a misconception: Roth's aren't like CDs, where the return is pre-defined, explains Philip Liberatore, certified public accountant and founder and director of IRS Problem Solvers. A Roth is just a type of investment account, and its actual return depends on the performance of the investments used within it.

Where's My Deduction?

People often get Roth IRAs confused with the Traditional IRA, which gives investors a tax deduction today. "People often lose sight of how useful that can be and are disappointed to learn that they do not get that with a Roth IRA," says James Kennedy, a financial adviser with Kennedy Financial Strategies.

Seniors Can Play Too


Older people often think that they are past the age to contribute to their IRA. Roth IRAs, though, differ from all other tax-deferred retirement plans in that they have no mandated age at which you have to start taking distributions, so you can continue to contribute after you are 70½.

Yes, There Are Limits


You can't save any amount that you want. The IRS allows a maximum contribution of $5,000 per year, plus an additional $1,000 "catch-up" for people over 50. Contributions can only be made if you have earned income that year, notes Rob Conderman of Angelo Planning Group, because only earned income can be contributed to a Roth.

There are also maximum income limits on the Roth IRA: If you earn too much, you can't contribute. But that income limitation for Roth IRAs is applied at year end, not at the time of contribution. "So if you exceed the income limitation at year end (unexpectedly), and have contributed to the Roth, you must get the contribution out, or pay a penalty of 6%," says Timothy Gagnon, assistant academic specialist of accounting at Northeastern University.

And while there are income limits on the Roth IRA, anyone can contribute to a Roth 401(k) plan. "Don't forget to ask your employer if there's a Roth 401(k)," recommends James Carroll, president of Financial Advisors of Southwest Florida. "More and more 401ks are including the Roth 401(k)." Be aware, however, that with a Roth 401(k), mandatory withdrawals kick in when you're 70½.

No RMDs ... For You

Unlike some other investments, there are no Required Minimum Distributions during the original owner's lifetime with the Roth IRA. But inherited Roth accounts are subject to beneficiary RMD rules.

Few things in life are free, but you don't have to worry about Uncle Sam shaking you down for taxes in retirement when you tap the cash from your Roth IRA -- that alone might make a Roth ideal for part of your stash.

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44 Comments

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bob.keren

I'd rather use Roth IRA's for dividend stocks. It makes the dividends better knowing they won't be taxed. Plus a Roth IRA should be one of your conservative accounts when it comes to retirement. Save the risky picks to your active unlimited account. Roth IRA's are limited to $5000 a year which doesn't go far. http://fidelityrothira.net

September 12 2011 at 4:57 PM Report abuse rate up rate down Reply
keybdkat

"Unlike some other investments, there are no Required Minimum Distributions during the original owner's lifetime with the Roth IRA. But inherited Roth accounts are subject to beneficiary RMD rules."

Yes, BUT, structured correctly it is a windfall for a family member or members - instead of leaving the Roth IRA to the spouse, leave it to a much younger family member (i.e. son, daughter, grandchild) and the RMDs are based on such a long lifespan that the IRA will grow compounded at a faster rate than the RMDs deplete the account. Also, if the inherited Roth IRA is within the estate tax exemption limit, you now have an IRA free from estate and income tax !

June 09 2011 at 4:22 AM Report abuse rate up rate down Reply
bucher7743

How and why does congress make it so very difficult for the individual to cope with the Byzantine stipulations associated with the various savings accts IRA"S etc. Nominally these type acounts were to benefit the older people . Congress and the Washington bunch in general gum up things so that savers have to run a gauntlent of difficult rules that mkes the whole process a great pain and expensive to handle gb.

June 06 2011 at 12:03 AM Report abuse rate up rate down Reply
djgarman

My E-mail is djgarman@aol.com

June 03 2011 at 11:01 AM Report abuse rate up rate down Reply
djgarman

The statement that You can't touch your cash without penalty until 59 and one half is NOT correct Ajso you do not have to wait five years to withdraw any money you contributed to your Roth IRA. You can't withdraw any earn incom until five years and 59 and one half is for a regular IRA.
You do not have to have earn income yourself. If your spouce has earn incme you are entitled to contribute to your own Roth IRA. I have been doining it for the last six years.

June 03 2011 at 10:58 AM Report abuse rate up rate down Reply
scottee

I think all federal employees, starting with congress, should pay into social security and buy their own IRAs for their pensions.

June 03 2011 at 8:02 AM Report abuse +2 rate up rate down Reply
Bracer

Warning to all:
Roth conversions are extremely complicated. I have read only a handful of posts here, and almost all that I have read have factual errors. Further, the author of this article left out many of the finer details(as do most journalists that cover this subject). If you are considering a Roth conversion, you need to seek the help of a qualified financial planner to make sure you understand it all.

June 03 2011 at 6:42 AM Report abuse +1 rate up rate down Reply
davefromfwb1

The government just wants you to put money in this so that when you die they'll get all the money. I'm single, no kids, not married and I plan on working till I die. Now that's the American dream.....forced upon me by the corrupt government we have and will always have.

June 02 2011 at 10:31 PM Report abuse +1 rate up rate down Reply
2 replies to davefromfwb1's comment
Bracer

The government dos not take your IRA when you die....thats complete hogwash.

June 03 2011 at 6:25 AM Report abuse rate up rate down Reply
UnderSerf

Most ppl don't seem to GET the fact that it's ALL gubmint money, if you do any one of (nowadays) a hundred things the gubmint finds worthy, you will lose whatever you saved, Period - regardless how that money was earned, you could find it confiscated.

June 03 2011 at 10:33 AM Report abuse +1 rate up rate down Reply
rmrnite

They missed a huge loop hole in the current law, anyone at any age regardless of income can open up a traditional
IRA pay in the maximum then convert it to a Roth IRA and never pay taxes on it again. So if normally don't qualify
to set up a Roth IRA due to income this is your work around,so you don't deduct the initial contribution to the traditional
IRA because of income, then convert it to a Roth IRA and not pay any federal tax on the switch over because you never
deducted it in the first place, now you have a tax free Roth IRA. ask your CPA about this.

June 02 2011 at 10:00 PM Report abuse +1 rate up rate down Reply
1 reply to rmrnite's comment
Bracer

You are over simplifying something that is very complex.
1. You must have earned income(income from a job) to open any kind of IRA. Thus, anyone at any age CANNOT open an IRA.
2. You cannot pick and choose which portion of your IRA you want to convert. There are IRA aggregation rules that come into play when converting from an IRA to a Roth.
3. Finally, if you think the average CPA knows about these complex rules, you are sadly mistaken. Most CPA's(as the public thinks of them) know how to make money preparing tax returns, thats about it. Dont expect any complex tax planning unless you are a business client paying lots of money, and you are dealing with a CPA that specializes in that area.

Hopefully you didn't cause too much damage with this uninformed post.

June 03 2011 at 6:24 AM Report abuse rate up rate down Reply
Chuck Crow

Give the liberals a chance and it will be taxed after the fact. They will try if they get a chance, count on it.

June 02 2011 at 8:30 PM Report abuse -4 rate up rate down Reply