Roth IRA Rules

The Roth IRA allows you to grow your tax money tax-free after contributing money that you already paid taxes on (called after tax contributions) . Therefore, you cannot deduct contributions to a Roth IRA because you get the tax benefit in the tax-free growth.

Qualified distributions from that point on are tax-free. Another advantage of a Roth IRA is that if you need emergency access to your own money that you contributed, you are not hit with a 10% tax penalty just for using your own money!

For example, if you contribute $5,000 to a Roth IRA and take $5,000 out a year later, you can take it out penalty free. However, once you start taking money out of the Roth IRA, you must show that it does not consist of earnings or other taxable amounts since these funds may be subject to tax and a 10% tax penalty for early distributions.

Roth IRA ordering rules determine which funds we're withdrawn first. The bottom line is that you have to be careful not to take funds that are subject to the 10% penalty and tax, so it is best to just leave your money in a Roth IRA for five yearsanduntil you are age 59 1/2 to reap the full benefits of a Roth IRA. However, since emergencies sometimes happen, follow the ordering rules to avoid any unnecessary tax penalties and taxes.

One of the other biggest distinctions between a Roth IRA and a traditional IRA is that there are no minimum required distributions when you turn 70 1/2. This also means you are not subject to the jaw-dropping 50% tax penalty for not taking a distribution, and you can even leave the entire account to your heirs tax-free. This is an enormous tax advantage of the Roth IRA.

Roth IRA Rules Summary

Roth IRA Rules follow the same rules as a traditional IRA except:

  • You cannot deduct contributions to a Roth IRA.
  • If you satisfy the requirements, qualified distributions are tax-free.
  • You can make contributions to your Roth IRA even after you reach age 70 .
  • There is no required minimum distribution; you can leave amounts in your Roth IRA as long as you live.
  • The account or annuity must be designated as a Roth IRA when it is set up.

The Five year Rule

The five year rule states that any distribution made during the five-year period for which you made a Roth IRA contribution or conversion is not a qualified distribution, and may be taxable, regardless of why you took the distribution. The five year rule for the Roth IRA is therefore a main factor in determining whether or not your distribution is a qualified distribution . This is important because once you leave your money in the Roth IRA for five years and you are age 59 1/2, withdrawals become tax-free .

The Roth IRA holding period begins on the first day of the year of the Roth IRA contribution. For example, if you contribute to your Roth IRA in November of 2012, then your Roth IRA holding period begins on January 1, 2012. Similarly, if you contribute to your Roth IRA on April 15, 2013, and you designate tax year 2012 as the contribution year, then the Roth IRA holding period begins on January 1, 2012.

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Roth IRA Conversions and the Five year Rule

Roth IRA conversions are also subject to the five year rule which begins on the day the funds leave the traditional IRA, regardless of when the funds are deposited into the Roth IRA. Keep in mind that a conversion is subject to a 60-day rule similar to a rollover in which you have 60 days to deposit the funds or it is considered a distribution subject to taxes and a 10% penalty. To avoid any delay, a trustee-to-trustee transfer is best which moves the money directly from one financial institution or account to another. A trustee-to-trustee transfer takes a few days at most, and is instantaneous if both accounts are at the same financial institution.

When you receive the money yourself, you have 60 days to deposit the same amount of money that left the traditional IRA into a Roth IRA or it is considered an early withdrawal subject to tax and the 10% penalty. This means you cannot pay taxes by taking the money from the IRA funds because any funds you take from your IRA count as a distribution, not a Roth IRA conversion, so it is subject to a 10% tax penalty (if you are under 59 1/2) plus additional taxes. You should therefore have funds set aside to pay taxes to convert the funds to a Roth IRA, or convert a smaller amount that you can pay the taxes on from other funds (e.g. checking or savings accounts).

If you convert another account into a Roth IRA, then the five-year holding period starts over.

What are Qualified Distributions?

A qualified distribution is any payment or distribution from your Roth IRA that has been held in the Roth IRA account for five years and also meets one following requirements:

  • Made on or after the date you reach age 59,
  • Made because you are disabled,
  • Made to a beneficiary or to your estate after your death, or
  • Special purpose distribution, for example $10,000 of distributions you receive to buy, build, or rebuild a first home.(You are a first-time homebuyer if you had no present interest in a main home during the 2-year period ending on the date of acquisition of the home which the distribution is being used to buy, build, or rebuild. If you are married, your spouse must also meet this no-ownership requirement.)

Roth IRA Contribution

Generally, you can contribute to a Roth IRA if you have taxable compensation (defined later) and your modified AGI (defined later) for 2011 isless than:

What is Taxable Compensation?

For purposes of an IRA, taxable compensation includes wages, tips, salary, commissions, self-employment income, or other income as outlined in the below table.

earnings from propertycommissionspension or annuity incomeself-employment incomedeferred compensation (compensation payments postponed from a past year)alimony and separate maintenanceincome from certain partnerhips that you do not materially participate innontaxable combat payany amounts you exclude from income such as foreign earned income and housing costs

Roth IRA Conversion

Beginning in 2010, you can convert your retirement accounts to a Roth IRA with no restrictions on the amount after 2010.

This is because Congress through The Tax Increase Prevention and Reconciliation Act (TIPRA) eliminated income and filing tax restrictions for Roth IRA conversions, which means you can convert your traditional IRA into a Roth IRA regardless of income and filing status. Keep in mind that for Roth IRA contributions, the income limits still apply. If you would like to convert a sizable amount of your traditional IRA into a tax-free Roth IRA, however, TIPRA removes the conversion restrictions.

Roth IRA Ordering Rules

Roth IRA ordering rules determine which funds we're withdrawn from your Roth IRA based on a set order. The purpose of the ordering rules is to determine which part of early withdrawals are taxable or nontaxable since earnings distributed early are taxable and subject to a penalty, whereas other items such as contributions are never subject to tax. The ordering rules are as follows:

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Sources

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Posted in Business Service Post Date 09/01/2015


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