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WIKI ANALYSIS
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This article is a part of Wikinvest's Personal Finance section and Guide to Investing. Please contribute or edit to improve it. |
A Roth IRA is a retirement plan in the US which allows investments to grow without being taxed. Unlike the traditional IRA, the Roth IRA does not offer tax deduction for contributions. However, if certain requirements are met, the Roth IRA allows all investment earnings to be withdrawn tax-free.
Other benefits of these accounts include avoiding the early distribution penalty on certain withdrawals, and eliminating the requirement to take minimum distributions after age of 70½. The maximum contribution to IRA accounts are are limited to $5,000 ($6,000 for people over the age of 50) or total annual income, whichever is lower. In the case of married couples, each spouse is eligible to contribute individually. The account holder can use the money in these accounts to invest in all types of financial securities: such as stocks, bonds and mutual funds.
The Roth IRA named after Senator William Roth who was the legislative sponsor of these accounts under the Taxpayer Relief Act of 1997.
Eligibility
- Unlike a traditional IRA, which are not open to minors and persons over the age of 70½, Roth's IRAs have no age limits. An individual can open a Roth IRA anytime as long as he/she funds it through "compensation earnings". Compensation includes all payments from employers, or earnings from self-employed business and partnerships. For the purposes of determining IRA limits, alimony is also treated as compensation
- A person is eligible to a Roth IRA even if she is participating in a retirement plan sponsored by her employer (such as a 401k and Roth 401k).
- The maximum contribution is limited to $5000 per year for individuals below the age of 50, and at $6,000 for individuals above 50. However, these limits are reduced for people who earn less than these amount in "compensation", i.e. contributions to the IRA must come from "compensation" earned during the year.
- In the case of Spousal Roth IRA, an individual can contribute up to the limit as long as his/her spouse earns enough compensation to cross the limit.
- As of 2008, Roth IRAs are available to individuals whose income (technically, modified adjusted gross income) is below $101,000 (single) and families with a joint income below $159,000 (married filing jointly). As income rises above these levels, the Roth IRA contribution allowance is phased out and eventually eliminated
- The amount an individual can contribute to a Roth IRA is reduced by two other contributions:
- Contributions to a traditional IRA (except for rollover contributions)
- Contributions to a "501(c)(18) plan", which are employee funded pension plans created before June 25, 1959
- Contribution to SEP IRA or SIMPLE IRA do not reduce the amount one is eligible to contribute to a Roth IRA, unless it is a regular "IRA-type" contribution.
How to Start a Roth IRA
Roth IRAs are managed by custodians. Custodians can be any type of financial institutions which offer IRA accounts. Banks, insurance companies, mutual funds and brokerage firms are all valid IRA custodians. A person can walk into any of these institutions and fill up a form to start an IRA account.
There are two ways to fund a Roth IRA. An investor can start by directly funding the Roth IRA account or by converting parts of a traditional IRA into a Roth IRA. The institution managing the IRA will have details on how to accomplish this.
Advantages of Roth IRA
- Tax Benefit: Roth IRAs do not tax earnings from dividends and capital gains unless it is withdrawn early. For those who are in lower tax brackets than they will be in retirement, the growth of assets in a tax free environment allows the power of compounding interest to have great effect.
- Withdrawal Ease: An individual can withdraw contributions to a Roth IRA, i.e. money that he or she directly put in, anytime without having to pay any taxes. Withdrawals of earnings are tax-free if the investor is over age 59½ and at least five years have expired since the Roth IRA was established. Otherwise (with limited exceptions) these earnings are taxable and likely to be subject to early withdrawal penalty.
- No Minimum withdrawal allows estate planning benefits: The Roth IRA does not require distributions (withdrawals) based on age. All other tax-deferred retirement plans, even the Roth 401(k), require withdrawals to begin by April 1 of the calendar year after the owner reaches age 70½. If an investor does not need the money and want to leave it for his heirs, Roth IRA's offer a great way to earn dividends and capital gains tax-free. However, beneficiaries who inherit Roth IRAs are subject to the minimum distribution rules.
- Protection from Bankruptcy and creditors: Up to $1,000,000 of Roth IRA assets can be exempt from a bankruptcy under the US bankruptcy code. Many states also have laws that prohibit judgments from lawsuits to be satisfied by seizure of IRA assets. However, the protection does not normally apply in the case of divorce, fraud, failure to pay taxes, and deeds of trust.
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