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:

Single Filers
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:

Example
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.

Conclusion
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.

Related Articles
  1. Taxes

    Tax Treatment Of Roth IRA Distributions

    Learn the requirements for withdrawing funds tax and penalty free.
  2. Retirement

    Roth Vs. Traditional IRA: Which Is Right For You?

    To answer this question, you need to consider several of the factors we outline here.
  3. Retirement

    Did Your Roth IRA Conversion Pass or Fail?

    If you are moving assets from a Traditional IRA to a Roth IRA, you need to know the associated tax rules.
  4. Professionals

    Your 401(k): How to Handle Market Volatility

    An in-depth look at how manage to 401(k) assets during times of market volatility.
  5. Professionals

    How to Build a Financial Plan for Gen X, Y Clients

    Retirement is creeping closer for clients in their 30s and 40s. It's a great segment for financial advisors to tap to build long-term client relationships.
  6. Professionals

    Don't Let Your Portfolio Be Trump'd by Illiquidity

    A look at Donald Trump's statement of finances and the biggest lesson every investor can learn.
  7. Professionals

    What to do During a Market Correction

    The market has corrected...now what? Here's what you should consider rather than panicking.
  8. Retirement

    Maxing Out Your 401(k) Is Profitable: Here's Why

    It's shocking, but most American workers (73%) have no 401(k) retirement funds. Start saving now to anchor your retirement.
  9. Professionals

    Top Questions to Ask When Choosing a Robo-Advisor

    Think a robo-advisor might be the right choice for you? Be sure to ask these questions first.
  10. Professionals

    Top Retirement Hack? Start with a Lifestyle Change

    Instead of going through the usual retirement planning steps, some people are focusing on fostering a lower cost lifestyle from the start.
RELATED TERMS
  1. Qualified Longevity Annuity Contract

    A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
  2. See-Through Trust

    A trust that is treated as the beneficiary of an individual retirement ...
  3. Backdoor Roth IRA

    A method that taxpayers can use to place retirement savings in ...
  4. Current Service Benefit

    The amount of pension benefit accrued by an employee who had ...
  5. Self Invested Personal Pension ...

    A tax-efficient retirement savings account available in Great ...
  6. Elder Care

    Elder care, sometimes called elderly care, refers to services ...
RELATED FAQS
  1. Can you buy penny stocks in an IRA?

    It is possible to trade penny stocks through an individual retirement accounts, or IRA. However, penny stocks are generally ... Read Full Answer >>
  2. Can I use my IRA to pay for my college loans?

    If you are older than 59.5 and have been contributing to your IRA for more than five years, you may withdraw funds to pay ... Read Full Answer >>
  3. Can my IRA be used for college tuition?

    You can use your IRA to pay for college tuition even before you reach retirement age. In fact, your retirement savings can ... Read Full Answer >>
  4. Why are IRA, Roth IRAs and 401(k) contributions limited?

    Contributions to IRA, Roth IRA, 401(k) and other retirement savings plans are limited by the IRS to prevent the very wealthy ... Read Full Answer >>
  5. How do you calculate penalties on an IRA or Roth IRA early withdrawal?

    With a few exceptions, early withdrawals from traditional or Roth IRAs generally incur a tax penalty equal to 10% of the ... Read Full Answer >>
  6. What are the best ways to use your 401(k) without a penalty?

    The best way to use your 401(k) retirement savings account is to take normal distributions after you reach retirement age. ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!