Have you ever wondered what’s so important about Roth IRAs? Does it seem that no matter how many articles you read on the topic, the facts are still fuzzy? All this talk about conversions, recharacterizations, and rollovers can be confusing. Look no further... we’ll explain all the details about Roth IRAs in plain English.
In a traditional IRA, you can deduct what you contribute, up to a limit. But with the Roth IRA, you cannot deduct what you contribute. You are depositing a contribution after taxes. But you get other tax advantages that are not available with a traditional IRA. For example:
- You do not have to stop making contributions at a certain age.
- You do not have to start taking money out at a certain age.
- You do not get taxed on withdrawals, in retirement.
If you're thinking about a Roth IRA, here are answers to common questions:
How Much Can I Contribute Each Year to the Roth IRA?
You can contribute up to $3,000 each year (or up to the amount of your compensation, if it’s less than $3,000). If you are 50 or older, you can pitch in another $500 a year. These rules are the same as for a traditional IRA.
Can I Contribute to Both a Traditional IRA and a Roth IRA?
Yes. You certainly can, but the total that you can contribute to all of your traditional IRAs and Roth IRAs combined is $3,000 per year ($3,500 per year if you’re 50 years old or older). This means that if you contribute $2,500 to a traditional IRA, the most you can contribute to a Roth IRA is $500 ($1,000 if you’re 50 years old or older).
Is the Money Taxable When I Take it Out of the Roth IRA?
No! Because you have already paid taxes on your contributions to the Roth IRA, they are not taxed when you withdraw the money. But here is good news: the income that your Roth IRA earns isn’t taxable when you take it out, which is the major difference between the Roth IRA and the traditional IRA. You can make nondeductible contributions to a traditional IRA, but when you take the money out, the earnings that have accumulated are taxable.
Are Withdrawals from my Roth IRA Always Tax-Free, Regardless of When I Withdraw the Money?
Yes, if each withdrawal is a "qualified" distribution.
For a distribution to be qualified, you must leave the money in your Roth IRA for five tax years, beginning with the first year you made a contribution. Before you can start taking money out tax-free, you must also be at least 59-1/2 years old, become disabled, die, or use the money (up to $10,000) to buy a first home for you, your spouse, child, or grandchild.
Remember: IRAs were created to provide another "safety net" for your retirement years.
Do I Have to Stop Making Contributions to a Roth IRA After I Reach a Certain Age?
No. You can contribute to a Roth IRA, even after you reach the age of 70-1/2 (unlike a traditional IRA). Also, you can still make contributions even after you retire—as long as you’re earning money.
Do I Have to Start Taking Money out of the Roth IRA by a Certain Age?
No. Unlike traditional IRAs, where you usually must withdraw at least a minimum amount of money every year after you turn 70-1/2, Roth IRAs impose no age or amount restrictions on withdrawals.
Are Roth IRAs Available to All Taxpayers?
When your adjusted gross income hits $150,000 (for married couples filing jointly) or $95,000 (for all others), the contribution you’re allowed to make starts decreasing, and disappears altogether after your income passes $160,000 (married filing jointly) or $110,000 (all others).
Any contributions you make over the allowed amount are subject to a 6% penalty. Refer to IRS Publication 590: Individual Retirement Arrangements for more information about contribution limits.
Can I Rollover Money from One Roth IRA to Another Roth IRA?
Yes. You can transfer the Roth IRA funds that you’ve accumulated to another Roth IRA account, and because you are transferring the funds to another IRA of the same type, you have just performed a rollover.
The way you make the rollover dictates how much work you will face when you do your taxes.
When you ask your bank or other IRA custodian to do a direct transfer from your Roth IRA account to another Roth IRA account, the IRS doesn’t require your bank to issue a Form 1099-R, which means that you don’t have to report this transaction on your tax return.
If you pull money out of one Roth IRA account yourself, then redeposit the money into another Roth IRA account within 60 days, you need to report the rollover to the IRS, even though you don’t have to pay any taxes on it.
For more information, see How Rollovers Work.
Can I Transfer Money from a Traditional IRA to a Roth IRA?
Yes, but not tax-free. This kind of transfer is called a conversion. You normally get taxed on withdrawals from your traditional IRAs. In other words, you can’t pull the money out of your traditional IRAs and put it into a Roth IRA without getting taxed. Think about it: the money you withdraw from a Roth IRA is not taxable: if you weren’t taxed on your traditional IRA withdrawal, you would escape taxes altogether! Congress has made sure this can’t happen.
There is one hitch, however: You can only transfer your money from your traditional IRA to a Roth IRA if your modified adjusted gross income (MAGI) is $100,000 or less.
If your MAGI is more than $100,000:
- The amount you withdrew from your traditional IRA is considered to be a distribution, and if you are under 59-1/2, this is an early distribution subject to a penalty.
- The amount you converted to a Roth IRA is considered to be a contribution, not a conversion, which means that it is subject to the penalty for excess contributions to a Roth IRA.
Also, if you’re married filing separately, you can’t transfer money regardless of your income if you lived with your spouse at any time during the year.
If conversion does not look right for you, consider recharacterizing the money.
What is a Conversion?
A conversion is a transaction in which you remove funds from a traditional IRA, a SEP IRA, or a SIMPLE IRA and put them into a Roth IRA. You can convert the entire amount of your non-Roth IRAs into a Roth IRA, as long as your adjusted gross income is $100,000 or less.
You can’t convert funds from a Roth IRA to a traditional, SEP, or SIMPLE IRA.
Why would you want to do this kind of conversion? Remember that with Roth IRAs, you pay taxes on your contributions now, not on the distribution when you retire. If you think you would be better off paying the taxes on the distributions now instead of when you are on more of a fixed income, you might want to convert your traditional, SEP, or SIMPLE IRA to a Roth IRA, pay the taxes now, and withdraw the funds completely tax free after your retirement.
What is a Recharacterization?
Besides being an unwieldy term, a recharacterization is a trustee-to-trustee transfer of funds from a traditional IRA (NOT including a SEP IRA or SIMPLE IRA) to a Roth IRA, or from a Roth IRA to a traditional IRA, SEP IRA, or SIMPLE IRA.
The trustee-to-trustee transfer is important: if the transfer isn’t from trustee to trustee, it goes through you, and then it’s considered a withdrawal, and subject to penalties.
Recharacterization isn’t a bad idea: you’re redesignating one type of IRA as another type of IRA. The transfer includes any gains or losses, but the amount recharacterized does not include any gains or losses incurred after the initial contribution or conversion.
- You might want to recharacterize your original contribution to a Roth IRA as a traditional IRA if you find that you earned too much money to contribute to a Roth IRA.
- You might want to recharacterize your traditional IRA as a Roth IRA if you find out that your traditional IRA contribution won&rsquo't be deductible because you make too much money, but you still earn less than the maximum Roth IRA income amount.
There are three possible types of recharacterizations:
- You can recharacterize a regular, annual contribution to a traditional IRA as a Roth IRA as long as you do it in the same year you made the contribution. You cannot recharacterize any amounts in the traditional IRA that are not a direct result of a regular contribution for the same year: those amounts must be converted.
- You can recharacterize a regular, annual contribution to a Roth IRA as a traditional IRA contribution. The recharacterization must be for the same year that you made the contribution. You cannot recharacterize any amounts in the Roth IRA that are not a direct result of a regular contribution for the same year.
- If you converted an amount from a non-Roth IRA to a Roth IRA, and then found that you made more than $100,000 this year and are therefore not eligible for the Roth IRA, you can avoid penalties and go back to your non-Roth IRA by performing a recharacterization. You can’t perform another conversion to go back to where you were: you must recharacterize the Roth IRA as a non-Roth IRA to avoid penalties and other problems.
In addition, the recharacterization must be the direct result of a conversion. You cannot recharacterize any amounts in the Roth IRA (such as regular contributions) that are not a direct result of a conversion.
What Can I do if I Contributed Too Much to a Roth IRA?
You have two options—withdrawing or recharacterizing.
You can withdraw the excess contribution before the due date (including extensions) of your tax return. You must also withdraw any earnings on the excess contributions. You will have to pay tax on the earnings you withdraw, but not on the contribution itself.
If you are under age 59-1/2, you may also have to pay a 10% early withdrawal penalty.
You can recharacterize part or all of the contribution as a traditional IRA contribution. To do a recharacterization, you must do a trustee-to-trustee transfer of the contribution from the Roth IRA to a traditional IRA. You must also transfer any earnings on the contribution you recharacterize.
Your contribution is treated as if you contributed it to the traditional IRA on the same day you originally contributed it to the Roth IRA--as if you never made the contribution to the Roth IRA. If you recharacterize a contribution, the transaction is not taxable.
What do I do if I Make a Conversion From a Traditional IRA to a Roth IRA and Then Find out I was Not Allowed to do so?
If you are in this situation, you must "undo" or recharacterize the conversion. Just as with the recharacterization of a regular contribution, you must do a trustee-to-trustee transfer of the amount you converted. You must also transfer any earnings or losses on the converted amount. The net result: the money goes back to the traditional IRA as if the original conversion never took place.
Can I put Money into a Roth IRA Other Than by a Regular Contribution or a Conversion?
Yes. If you make a contribution to a traditional IRA, you can recharacterize that contribution as a contribution to a Roth IRA for the same year. You must do a trustee-to-trustee transfer of the contribution from the traditional IRA to the Roth IRA and must also transfer any earnings on the contribution.
If you do this, your contribution is treated as if you contributed it to the Roth IRA on the same day you originally contributed it to the traditional IRA--as if you never made the contribution to the traditional IRA.
Can I Recharacterize a Traditional IRA as a Roth IRA?
You can only recharacterize a contribution to a traditional IRA that was made in the same year. Any money in a traditional IRA that is not part of a current-year contribution must be converted, not recharacterized.