Since its introduction under the Taxpayer Relief Act of 1997, the Roth IRA has become a popular retirement and estate-planning tool among U.S. taxpayers. According to a study done by the Investment Company Institute, Roth IRA assets increased to from around $57 billion in 1998 to roughly $310 billion as of 2012 year-end . However, many individuals are prevented from participating in the Roth IRA because of the stringent qualification requirements. Here we revisit some of these requirements and explore some qualification opportunities that may be available to certain individuals.
Roth IRA Contributions
A Roth IRA may be funded through regular IRA contributions and assets converted from Traditional, SEP or SIMPLE IRAs, as well as qualified, 403(b) or governmental 457 plans. To make regular IRA contributions, an individual must have eligible compensation for the year and must meet the following requirements:
In 2013, if an individual's tax-filing status is 'single', his or her modified adjusted gross income (MAGI) must not exceed $127,000. An individual filing single may contribute up to $5,500 + catch-up for 2013 if his or her MAGI is less than $112,000. For individuals whose MAGI is between $112,000 and $127,000, the contribution limit is 'phased out'. This means a special formula must be used to determine the dollar amount that such individuals may contribute to the Roth IRA for the year.
Married Filing Jointly
In 2013, if an individual's tax-filing status is married filing jointly, Roth IRA contributions are not allowed if the combined MAGI of both spouses exceed $188,000. Each spouse may contribute up to $5,500+ catch-up if their combined MAGI is not more than $178,000. If the couple's MAGI is between $178,000 and $188,000, the contribution limit is phased out.
Married Filing Separately
In 2013, if an individual's tax-filing status is married filing separately, his or her MAGI must not exceed $10,000. If his or her MAGI is between $0 and $10,000, the contribution limit is phased out.
If you fall within the phase-out range, you may still find it in your best interests to seize the opportunity to fund the Roth IRA. In most cases, analysis shows that the benefit of funding the Roth IRA at any allowable amount outweighs the benefits of funding a Traditional IRA.
Roth IRA Conversions
Individuals may also fund a Roth IRA by converting or rolling over amounts from non-Roth retirement accounts. Prior to 2010, this was not permitted for individuals with MAGI of more than $100,000, and those who filed as married filing separately. These restrictions were repealed as of January 1, 2010.
Starting the Five-Year Clock
The benefit of funding a Roth IRA instead of a Traditional IRA is the possibility of tax-free distributions. However, Roth IRA distributions are tax free only if they are qualified.
To increase the chances of a Roth IRA distribution being qualified, an individual will want to determine the earliest possible start date of the five-year qualifying clock. For an individual who has more than one Roth IRA, the five-year clock usually starts with the Roth IRA that received the earliest funding. The phrase to receive 'earlier funding' means something different than to be the first that was funded. The following example illustrates this difference:
Jane established Roth IRA No.1 in January 2013 and she converted her Traditional IRA assets to Roth IRA No.1 in 2013. Jane later established Roth IRA No.2 in April 2013, and on April 15, 2013, Jane made a contribution for 2012 to Roth IRA No.2.
Jane's five-year clock starts not in 2013- the year in which she funded her first IRA - but in 2012, the first earlier year to which the funding of her Roth IRA contribution applies.
Individuals whose income falls within the phase-out ranges may want to consider still contributing the reduced phase-out amount in order to get the five-year clock started.
Maintaining one Roth IRA for all conversions and contributions instead of multiple Roth IRAs may help reduce administrative and trade-related expenses. However, if you suspect that you may not be eligible to make the necessary type of transaction (a conversion or contribution) in a particular year, before putting the assets into one existing Roth IRA, you can maintain the assets in a separate Roth IRA until the eligibility is determined. Should you find that you are ineligible for the contribution or conversion, maintaining separate Roth IRAs will help eliminate the complex process of determining the net income attributable to the amount that needs to be recharacterized.
Excess Contributions and Recharacterizations Do Not Start the Five-Year Clock
Some individuals may want to contribute to their Roth IRAs but are unsure of whether their income will exceed the limits. These individuals should not be deterred from funding their Roth IRAs, as corrections can be made through recharacterization or a removal of excess contributions. Individuals should note, however, that Roth IRA contributions or conversions that are recharacterized or removed as a return of excess contributions do not start the five-year clock. Instead, for tax purposes, these amounts are treated as if they were never contributed to the Roth IRA.
If you converted your Roth IRA and the value has since declined, you may want to consider recharacterizing the amount and then reconverting the amount at a lower value. This reduces the taxable income from the conversion. There is a risk with this practice, however, because when you become eligible to reconvert, the assets might have since significantly increased in value.
During the last quarter of the tax year, when you, like many others, finalize your financial plans for the current year and explore opportunities for the upcoming year, you may want to revisit the eligibility rules for the Roth IRA as well as its features and benefits. But like any financial decision, deciding to fund a Roth IRA requires careful consideration. While the Roth IRA is an attractive financial and estate-planning tool, it may not be suitable for everyone. If possible, conduct your own research and talk to at least two financial planners, preferably from different firms, about how the Roth IRA fits into your financial profile. Ask for an analysis, pros and cons, and detailed explanations of any recommendations you are given.
TaxesLearn the requirements for withdrawing funds tax and penalty free.
RetirementTo answer this question, you need to consider several of the factors we outline here.
RetirementIf you are moving assets from a Traditional IRA to a Roth IRA, you need to know the associated tax rules.
ProfessionalsSoon to be retirees are often told it's best to wait until age 70 to collect Social Security. Here's why this is not always the best advice.
ProfessionalsBetween delaying filing, claiming strategies and taking advantage of special marital benefits, there are several ways to maximize Social Security.
RetirementSure, you can tap your permanent life insurance policy to help fund your retirement. But in most cases, an IRA is the better choice. Here's why.
Options & FuturesProfessionals choose the options available to you in your plan, making your decisions easier.
Investing BasicsChoosing a financial advisor isn't an easy task. Here's a list of the most important things to consider when planning for your financial future.
ProfessionalsCalmness, transparency and credentials (and more) are the key elements clients look for when selecting a financial advisor.
Investing BasicsDon’t skimp on the CFP designation. Here's why those three letters show that someone is qualified in financial and investment planning.
A longevity annuity may be right for an individual if, based on his current health and a family history of longevity, he ... Read Full Answer >>
Your Roth IRA account grows over time thanks to two funding sources: contributions and earnings. While your contributions ... Read Full Answer >>
As long as your retirement funds are held in your 401(k) and you do not take them as distributions, your 401(k) cannot be ... Read Full Answer >>
Whether your IRA can be taken in a lawsuit depends largely on your state of residence and the judgment in question. There ... Read Full Answer >>
Unlike a 401(k) or Individual Retirement Account (IRA), mutual funds are not classified as retirement accounts. Employers ... Read Full Answer >>
Though some states protect IRA savings from garnishment of any kind, most states lift this exemption in cases where the account ... Read Full Answer >>