One of the best saving and investment vehicles that you can and should establish is a Roth IRA. I just wish it was around when I graduated from university many moons ago. The Roth IRA has only been around since 1997. It’s called “Roth” simply because that’s the name of the U.S. senator (William Roth) who sponsored the bill that created it.
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I’ll tell you a lot more about the Roth IRA shortly, but there are two key things you should know about it.
What Makes a Roth IRA Unique?
First, you’ll contribute after-tax dollars to it. Think of after-tax money as your take home pay. This is different from a 401(k) or 403(b) plan, or Traditional IRA where your contributions are made with before-tax dollars.
Second, if you don’t make withdrawals from your Roth IRA before age 59.5, then all the money (including what your investments earn) will be yours tax-free. There’s no other investment vehicle like it.
If this doesn’t make sense yet, then read on.
First of all the “IRA” in Roth IRA actually stands for Individual Retirement Arrangement. That’s the official name. It is much more commonly referred to as an Individual Retirement Account by most people, but both names are acceptable.
With that bit of trivia out of the way, let’s get down to business. So you ask, “What is a Roth IRA?”
When it all comes down to it, it’s a type of holding account (or bucket) with a special label to remind you that this is where you are keeping your investments. The Roth IRA, itself, is NOT an investment. Instead, it is a place where you keep all of the other investments that you make with your retirement in mind.
Examples of the types of investments that you might drop into your Roth bucket include stocks, mutual funds, and bonds. Or you could even use it for an investment property purchase. You can also deposit money into it just as you would a regular bank savings account, to allow it to earn interest. Or, you could choose a combination of these or any of a number of other investment options.
Primarily, Roth IRAs are used for many combinations of stocks, bonds, mutual funds, and real estate. For most people who are just getting started with their Roths, one or two mutual funds may be all that the account initially contains. But as you get the hang of the process, you’ll become more confident in expanding your portfolio.
The most important part for you to remember is that a Roth IRA is not an investment. Think of it as a magical shopping cart that makes everything you place in it more special. The magic happens after you add investments in the cart. From that point on, if you don’t make any withdrawals before age 59.5, everything (profits and all) is yours tax-free.
For this reason, a Roth IRA is typically considered to be the best choice for most people, unless their earnings are exceptionally high.
What are the Eligibility and Qualification Requirements of a Roth IRA?
Roth IRAs are meant to make it more practical and appealing for regular working people to be able to build savings for their retirement. However, there are some people who don’t qualify for this kind of account. For example, the truly wealthy cannot establish Roth accounts.
Specifically, if your tax filing marital status is single, and your annual income is greater than $112,000 for 2013, then you will be somewhat, but not completely, limited in the amount you’ll be able to contribute to a Roth IRA. If your annual income is less than that amount, no problem.
Similarly, if your tax marital status is “married with joint filing”, then you will also experience contribution limitations if you have a household income that is greater than $178,000.
If your individual earnings are $127,000 or more, or if your joint married earnings exceed $188,000, then you cannot contribute to a Roth IRA.
These amounts are based on your Modified Adjusted Gross Income (MAGI) for 2013. If aren’t sure what MAGI is (or you’ve never heard the term before in your life), don’t concern yourself about finding out unless your earnings are close to the limit. For now just use your annual gross Income, before taxes. But if you’re curious, here how you’d calculate your MAGI.
Some other important Roth regulations that you should know about include the following:
- To be able to contribute to a Roth IRA, you (or your spouse) have to have earned money within that year. For example, you cannot contribute if all of your money that year was inherited.
- If you’re under the age of 50, your IRA maximum contribution is $5,500 for 2013. If you’re 50 or older, that bumps up to $6,500. This is important because the IRS could slap you with a penalty of 6 percent for excess contributions. Fortunately, if you realize that you have contributed too much, you have until the tax filing deadline (April 15, 2014) to withdraw the excess, as well as the related earnings, before there would be a penalty assessment.
- Roth IRAs can be used even if you have other retirement plans such as a 401(k), 403(b), traditional IRA, etc. (Note: You can have both Roth and Traditional IRAs, but you’ll have to split up the annual contribution limit between them.)
- Any contributions you make to your Roth must occur before each year’s tax deadline. For example, for 2013, your contribution deadline will be Tuesday, April 15, 2014.
For the legal nitty-gritty, straight from the horse’s mouth, just check the latest edition of the IRS Publication 590 (believe it or not, it’s not half as frightening and confusing as its snappy title implies), which can be found at: IRS Publication 590 . It will also give you the latest contribution limits for the current year.
- Determine if you qualify for a Roth IRA
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