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How it Works: Everything You Want to Know About the ROTH IRA

Statue of senitor

A Brief History

Along with the child tax credit, and a reduction in long-term capital gains rates the Taxpayers relief act of 1997 also created the Roth IRA. Named after Senator William Roth, the ROTH IRA was a new way to allow Americans to save for retirement. Giving them the choice of when to pay their taxes, now or later.

Drawing Later

How it works

Much like the traditional IRA, you must have earned income in at least the amount that you are contributing. The contribution limits are the same, which are $6,000 or $7,000 if you are over age 50 in 2022. You can invest your money in almost anything, cash, stocks, bonds The money that you contribute grows tax-deferred, but that is where the similarities end. With a ROTH IRA, you do not get a current tax deduction. The money you contribute is considered "after-tax" the benefit being that you don't pay any taxes when you withdraw the money and the money you withdraw will not add to your earned income, and because no taxes are due when you withdraw the money, it also eliminates the need for required mandatory distributions.

Man Waiting

But be Aware

Along with the traditional IRA, the government wants to promote savings for retirement. To that effect, there is a 10% penalty for withdrawing money before you reach the age of 59 1/2. Although you have already paid the taxes on your contribution, this only applies to the earnings. There is also the "5-year rule", meaning you can't withdraw the money, without penalty, until it has been 5 years since your first contribution. For example, If you open a Roth at age 58 you won't be able to take a penalty-free withdrawal until you are 63 even though you passed the 59 1/2 mark. Being able to contribute to a ROTH IRA is determined by how much money you make. Contributions begin to "phase out" starting if your modified adjusted gross income is over $129,000 if you file single or $204,000 if file married joint. Fully "phasing out" at $144,000 if you file single or $214,000 filing married joint.

Exceptions to the Rule.

Certain situations will allow you to take money out of your Roth IRA before the age of 59 1/2 or if you haven't passed the 5-year mark. avoid the 10% penalty

First-time home buyer: You can take up to 10,000 (lifetime maximum) from your Roth IRA for the purchase of a house if you qualify as a first-time home buyer. To qualify as a first-time home buyer you must have not owned a home within the last 2 years.

Substantial and Equal Periodic Payments: Also known as rule 72T allows you to take money out of a Roth IRA as long as you follow certain guidelines. The money must be withdrawn for a minimum of 5 years or until you reach the age of 59 1/2 whichever is greater. Meaning if you start taking withdrawals at age 40 you will have to stick with it for 20 years on the other hand if you take withdrawals at age 57 you will have to continue them until age 62. The government uses one of three methods to calculate the number of withdrawals amortization, annuitization, or required minimum distribution. You can pick the method that best fits your financial situation.

Unreimbursed Medical Expenses: If you have out-of-pocket medical expenses that are more the 7.5% of your adjusted gross income

Permanent Disability: If you qualify for the government's definition of permanent disability.

Education Expense: you can use your ROTH IRA to pay for qualified educational expenses for yourself or your immediate family. The withdrawal cannot exceed the amount of the qualified educational expenses.

For Birth or Adoption: you can take up to $5,000 from your ROTH IRA for expenses related to childbirth or adoption.

Reservist: a non-active reservist or National Guard member can make a withdrawal upon being called up for active duty.

Health Insurance Premiums: If you are unemployed for 12 weeks or more you can make a withdrawal to pay for your health insurance.

IRA Roth Conversion

One more thing of note

If you have already been contributing to a traditional IRA and feel that a ROTH would better suit your needs. You can convert either all or part of your IRA to a ROTH. You will have to pay the taxes on the money you convert but conversions are not subject to the income limits. In other words. If you couldn't contribute to a ROTH IRA because your income exceeds the "phase out" amount you could still convert an IRA. I would suggest doing a cost analysis first to see if it makes sense.

Keyboard withdraw button

Is a Roth IRA right for me?

If you are looking to save money for retirement and are not concerned with a current tax break in favor of a future one, then the ROTH IRA is a great fit. I should also mention that many company-sponsored retirement plans also have ROTH versions. As long as you don't go over the contribution limit you can contribute to both. For example, a person under 50 can contribute $3,000 to an IRA and $3,000 to a ROTH IRA for a total contribution of $6,000.



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