Roth IRA Basics: What to Know Before Opening a Roth


The Roth IRA is arguably one of the best retirement vehicles out there. It is important that you understand the basics of a Roth IRA. This basic knowledge will go a long way in helping you figure out whether opening and funding a Roth IRA would be in your best financial interest.

It’s my goal to discuss Roth IRA basics in very clear terms, forgoing any confusing terminology (which is tough to do if you’re talking about legislation in any form, and if this legislation affects taxes in any way? Your chances are even slimmer).

Roth IRA Basic Outline:

  1. What is a Roth IRA?
  2. Why should I open one?
  3. Who’s eligible for a Roth?
  4. How do I make contributions?
  5. When and how do I get distributions from my Roth IRA?

What is a Roth IRA?

A Roth IRA is a type or classification of an investment. So when someone says, “I have a Roth.” It really doesn’t tell you too much. That’s like me saying, “I have a car.” Neat-o. The more relevant question is probably, “What kind of car do you have?” Or, in retirement talk, “What assets are you holding in your Roth IRA?”

So remember, that a basic Roth IRA is simply a classification of an investment. You can hold almost anything in a Roth: mutual funds, single stocks, bonds, CDs, etc.

Now, because these investments you have are classified as a Roth (only certain institutions, such as banks, brokerage companies, or federally insured savings and loans or credit unions have approval from the IRS to offer Roth IRAs), it earns special treatment come tax time. One of the basic components of a Roth IRA is that your investment earnings grow tax-free, and are distributed to you tax-free, if the distributions are qualified.

Why should I open one?

An example will probably work wonders here:

Let’s say you contribute $1,000 after-tax income a year to your Roth IRA (below contribution limits, but just to keep it simple for now). And let’s say this $1,000 each year is invested in an S&P 500 Index fund. If you do this from age 25 to 65, at an average annual return of 10%, you will end up with $527,000. Now, remember, you contributed a total of $40,000 to your fund (40 years at $1,000 per year), so your investment grew $487,000. That whole $487,000 is tax free baby!

If you had simply invested that $1,000 in a normal mutual fund, where your earnings did not grow tax-free, and the capital gains rate remained at 20%, you would have a mere $291,000. So you can see that the Roth IRA, by being allowed to grow, and distribute its funds to you tax-free, saves you almost $200,000! That is sweet.

Who’s eligible for a Roth IRA?

You are eligible to open and/or contribute to a Roth IRA if you have taxable compensation during the year, or self-employment income (as with sole proprietors or partners). Your modified adjusted gross income (MAGI) cannot exceed certain limits however. These limits depend on your tax filing status, and are outlined below:

Filing Status MAGI Limit
Married filing jointly $160,000
Married filing separately, lived w/ spouse $100,000
Single, Head of Household, or Married filing separately, did not live w/ spouse $110,000

How do I make contributions?

If you’re working for an employer, basically your compensation that is eligible for contributions is anything in Box 1 of your W-2. This includes wages, salaries, commissions, and bonuses. If you’re self-employed, your eligible compensation consists of your net earnings less any contributions to retirement plans and less 50% of your self-employment tax.

There is, unfortunately, a limit to how much you can contribute to your Roth IRA each year. For the 2005 tax year, the limit is $4,000 per person. So, if you are married you could potentially contribute $8,000 in 2005 ($4,000 for you, $4,000 for your spouse). However, spousal contributions must meet the following requirements:

  • The couple must be married.
  • The couple must file a joint tax return.
  • The person making the contribution must have eligible compensation.
  • The total contribution made for both spouses cannot exceed the taxable compensation of the couple.

Rental income, and interest and dividends are not eligible for contributions.

When and how do I get distributions from my Roth IRA?

Alright, this gets a bit hairy, but it’s not really too bad. In order for a distribution to be tax and penalty free, it must be a qualified distribution. A qualified distribution must take place at least five years from the establishment of the Roth IRA and meet at least one of the following requirements:

  • The IRA holder is at least 59 1/2 years old when the distribution occurs.
  • A distrubtion of no more than $10,000 ($20,000 for married filing jointly) is used toward the purchase or rebuilding of a first home for the Roth holder, OR spouse, child, grandchild, parent, or ancestor of the Roth holder. This can only happen once per lifetime.
  • The distribution takes place after the IRA holder is disabled.
  • The assets are distributed to the spouse upon death of the IRA holder.

If an unqualified distribution is made then you will be required to pay income tax on any amount that was not an original contribution and an early-withdrawal penalty of 10%. This can be a huge hit. I strongly discourage taking any unqualified distributions. Certain exceptions apply, but for the sake of brevity (have I already lost my chance with that?) we won’t get into it.

Conclusion

As illustrated above, the Roth IRA is a powerful investment vehicle when used properly. You can potentially save yourself hundreds of thousands of dollars you might otherwise would have to hand over to Uncle Sam. I strongly encourage you to look into opening a Roth IRA so you can begin benefitting from the tax-free growth it offers.