What Is Roth IRA?
There are a million ways you can invest your money. And quite frankly, they’re not all created equal. Each investment is designed to meet different objectives and has different benefits. But to put it simply, a Roth IRA is the Cadillac.
A Roth IRA (Individual Retirement Account) is a privately sponsored investment vehicle that offers some very lucrative benefits. Perhaps the biggest is that the Government doesn’t tax any money that you withdraw from your account, as long as you are doing it according to the Roth IRA rules. Wow, talk about a tax break!
So when do you pay taxes on a Roth IRA?
The simple answer is when the Government takes their normal taxes out of your paycheck. That’s it. Although there are some tax guidelines to be aware of, essentially once your money is in a Roth IRA, it can sit there for 10, 20, or 100 years, never to be touched by the IRS.
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There are several other reasons why people love Roth IRAs. Here are just a few reasons why:
- You can use it as an emergency fund
- Use up to $10,000 of your Roth IRA to buy a house
- You direct how you would like the money in your Roth IRA invested
- Earn compound interest
- You can invest in both 401K and Roth IRA at the same time
- Take advantage of a 401K or IRA rollover or conversion to Roth IRA.
Like most investments, the earlier you start a Roth IRA, the better. In fact, it’s even more crucial with a Roth IRA, because you are only allowed to contribute a certain amount every year. So if you wait until next year, you essentially miss out on the contribution you could’ve made this year. Accordingly, It’s a good idea to figure out what the contribution limits are now so that you can get going ASAP!
The good news is that starting a Roth IRA is super easy. You can set one up in about 15 minutes without paying a cent. That’s right, although there are some companies that do require a minimum initial deposit, there are several discount brokers that don’t. Of course, if you invest nothing, you get nothing, if you invest a little, you get a little, and if you invest a lot, well…you get the picture. But if you can establish the discipline to make regular contributions, your Roth IRA will be an incredible cornerstone in your portfolio.
Opening a Roth IRA
Opening a Roth IRA is a matter of about 15 minutes online.
Select a Provider
There are tons of financial institutions that you can open a Roth IRA with. But they all boil down to 2 basic families: discount brokerages or full-service brokerages. A “discount broker”, offers a very streamlined service, and as the name indicates–low costs. These brokerages are geared more towards just making the transaction. The burden of deciding which investments to trade, when, and in what quantity rests largely on the individual. In this day and age, however, there is a ton of information available on picking investments. There are HUGE benefits to opening your Roth IRA through a “discount broker” such as ETrade or Zecco. Each of these brokers features:
- No minimum deposit (I literally opened my ETrade account with $0, and then funded it later)
- Low-cost trades (as low as $ 4.50 per trade at Zecco)
- “Commission-free” trades for certain new accounts
- The option to “rollover” an existing 401k or other retirement accounts
By contrast, A full-service or “traditional” brokerage, will assign you an investment adviser to act as your personal liaison with the market. He can offer trading advice personalized to your situation, buy or sell stock on your behalf, and prepare detailed reports on your portfolio’s performance. In exchange for this, a full-service brokerage will typically require a larger initial deposit to open an account with them and charge a higher commission on trades they place for you. If you are looking to get this personalized approach to your trading and don’t mind paying a slightly higher commission per trade, a full-service Roth IRA can still be a great option. Brokerages such as T.Rowe Price or Fidelity offer a great service for your Roth needs.
Submit Your Information
After you have selected your provider, setting up your account can be done online in 15 minutes. Although the sequence and some of the particulars may vary depending on the brokerage, you will be asked to:
- Establish your identity by submitting your social and some basic information.
- Indicate how you would like to make contributions–by check, electronically, on a regular basis (it can be set up with your bank account to receive regularly scheduled contributions).
- Designate beneficiaries for your Roth IRA to be distributed to upon your death.
- Set up some account information including a username and password.
After you have submitted this information, your Roth IRA will be created and you are off to the races! The next step is to choose your asset allocation and set up a contribution strategy.
Roth IRA Contribution Limits
Unfortunately, there is such a thing as too much of a good thing. The Roth IRA contribution limits are set up to regulate how much you are allowed to invest for each calendar year. This amount has fluctuated over the past few years, and will likely continue to do so, based on inflation rates and tax legislation.
For the tax year 2008, the maximum contribution any single filer could contribute was $4,000. In 2009 and 2010, the max contribution for a single filer is $5,000. If you are not eligible to
- Roth IRA Taxes
- Roth IRA and 401K (Contribute to both a 401k and Roth IRA).
- Contribution Strategy & Schedule
- Cash-out a Roth IRA
- Other Investment Vehicles
- Roth IRA Asset Allocation
- Roth IRA Calculator
Roth IRA Rules for Income/Contributing
You must receive some form of taxable compensation (salary, wages, tips, bonuses, fees, or other payment for services)
If your tax filing status is single, head of household, or married filing separately, your modified adjusted gross income may not exceed $105,000 if you want to make the full Roth IRA contribution.
If your filing status is joint, your modified adjusted gross income cannot be in excess of $166,000 in order to make the maximum contribution.
Assuming that you fall within the acceptable parameters for the first two criteria, your maximum contribution will be as follows:
- 2009: $5,000 or $6,000 if you qualify to make a “catch up” contribution.
- 2010: $5,000 or $6,000 if you qualify to make a “catch up” contribution.
- 2011: Contribution Limits to be determined (indexed to inflation).
Roth IRA Rules for Rollovers or Transfers
If you would like to transfer or rollover an existing retirement account to a Roth IRA, there are a handful of steps to ensure that it happens correctly.
1) Contact Your Current Financial Institution.
Notify them of your decision to rollover and ensure that there won’t be any fees or hidden charges to rollover to a Roth IRA account. If you would like to transfer funds from an employer-sponsored 401k, you must no longer be an employee of the company. It is important that the current institution is aware of this, or you could run into problems as you try to transfer the funds into a Roth IRA. Request the forms needed to process the rollover to a new financial institution.
2) Contact The Provider for Your New Roth IRA
Get in touch with the new financial institution and have them explain the process for a Roth IRA rollover. Some may require you to open a Roth first and then transfer, while others may have you complete the rollover at the same time you open your Roth. Make sure you understand the process and don’t hesitate to call more than once if you need to.
3) Complete the Paperwork
When it comes time to fill out all the paperwork, be sure you understand the forms completely. Make sure that you indicate that this will be a “Direct Rollover” so that the funds from your old account go directly to your new provider. Otherwise, the money will be sent directly to you and there could be taxes, penalties or fees assessed. Although it shouldn’t take long, an extra minute spent on doing it correctly the first time can save you a lot of time and headaches (and potentially earnings) in the future. If in doubt, check with your new provider that will be transferring your funds into a Roth IRA account. They will be much more likely to help you get your money transferred over to their institution.
4) Follow Up
Once the forms have been filled out and submitted, make sure you stay apprised of the status. If you haven’t heard anything for a couple of weeks, call to follow up with both providers. You may receive a check from your old provider that must be deposited into your new Roth IRA account. It is your responsibility to deposit this money with the new provider.
5) Get Cozy in Your New Home
Once your new Roth IRA account is funded, it will be your pleasure and responsibility to designate the asset allocation for those funds. In other words, how you would like your money in the Roth IRA account invested. This is a science unto its own and not an exact one at that. Do your best to be educated on this. Although there are enough opinions out there to make you dizzy, it will behoove you to understand what the pros and cons of each investment are.
One Final Note to Keep in Mind
Don’t forget that if your rollover to a Roth IRA is from a “pre-tax” investment vehicle, such as a 401K or a traditional IRA, you will be taxed on the amount that is being rolled over into your new Roth IRA. Essentially, you are making the decision to pay taxes on that money now rather than later. Smart move. Give yourself a pat on the back.
Using A Roth IRA as Your Emergency Fund
If you’ve heard of a Roth Ira, chances are you’ve also heard of using a Roth IRA as your emergency fund. Is that really possible? Well, to put it simply, yes. However, as the name indicates, a Roth IRA is designed primarily to be a retirement account, so many of the tax protections that your Roth enjoys are to encourage long term investing. But there are some exceptions which make your Roth IRA much more liquid than other retirement accounts.
Here’s what you gotta know:
- Contributions are the money that you put into your Roth IRA.
- Earnings refer to the interest that your contributions gain.
- Qualified Distributions are tax-free withdrawals that you can make when you’re using a Roth IRA as your emergency fund, or otherwise.
Why Save the Best for Last?
The best news is, that any money that you contribute can be withdrawn at any time without penalty. Be it a day, a month, or 30 years. If you put in $4,000, you can withdraw $4,000. Even though this amount isn’t considered a “qualified distribution” according to the IRS publication 590, it isn’t taxable. This fact alone makes using a Roth IRA as your emergency fund a good idea. Try putting 4 grand into a CD account for a week and then changing your mind–it doesn’t work.
How To Withdraw Your Earnings Tax-Free From Your Roth IRA
Ok, so what about withdrawing your earnings? Well, to make sure the public doesn’t abuse these tax privileges, there are certain government-mandated criteria for using a Roth IRA as your emergency fund. This makes it so you can’t just withdraw money from your Roth any time you want, for any reason you want. As a general rule, “qualified” withdrawals or distributions can be made after 1) a Roth IRA has been open for 5 years, and 2) the participant has reached the age of 59 and a half. If you are interested in using a Roth IRA as your emergency fund, there are certain situations where the number (2) can be waived. These include:
- If your withdrawal is made because you are disabled
- The withdrawal of up to $10,000 for the purchase of your first home.
- Upon your death, your Roth IRA can be distributed to your estate/beneficiaries free of tax
- Significant Unreimbursed Medical Expenses
- Paying Medical Insurance Premiums after losing your job
- Withdrawing up to but not in excess of your qualified higher education expenses.
- The distribution is due to an IRS levy of the qualified plan
- The withdrawal is a qualified disaster recovery assistance distribution
- The withdrawal is a qualified recovery assistance distribution
- The bad news is that If your withdrawal doesn’t meet the criteria to be considered a “qualified” distribution, it can be subject to a 10% early distribution taxed.
The “5 Year” Loophole
There is one loophole in the 5-year requirement that can be taken advantage of. The 5-year law governing Roth IRAs require that you must wait 5 years from the BEGINNING of the tax year that you first contribute. So if you open a Roth IRA in November of 2009, you will be eligible to make qualified withdrawals January 1st, 2014. You don’t have to wait for November to roll around.
It gets even better. You can actually open and contribute to a Roth IRA anytime up until you file your tax return for the previous year, and designate the contributions as being for that tax year. So in the example above, you could wait until April 14th of 2010, make a contribution and designate it as being for 2009, and still be eligible to receive qualified distributions on January 1st of 2014 (less than 4 years later). Not too shabby eh? Just make sure you correctly fill out the right tax forms when you are planning to withdraw.
Can I Roll My 401K to a Roth IRA?
Let’s say I have a 401k account that a previous employer set up for me. I am no longer working for that employer, and am therefore not making contributions to it. I’m now wondering if I can roll my 401k to a Roth IRA. Great news. Not only is it possible to roll your 401k to a Roth IRA, but it’s also actually pretty simple. There are, however, a few steps that need to be taken properly to ensure that your rollover to a Roth IRA is quick and seamless.
When Can You Cash Out a Roth IRA?
If you have a Roth IRA and would like to start reaping the benefits of your diligent savings, you’re probably wondering “When can you cash out a Roth IRA?” Here’s what you need to know:
You can cash out a Roth IRA when
It has been open for at least 5 years, and you are at least 59 1/2 years old.
These two criteria constitute the “bulletproof” rule for receiving qualified distributions from your Roth IRA. If these two criteria are met, you can withdraw as much or little money as you want, no questions asked, no taxes, no red tape, all of it straight to your pocket, amen and amen.
Ok, so what if you don’t meet one (or both) of the above criteria, but would still like to withdraw money from your account? You’re in luck. There are still options for you to cash out your Roth IRA without getting hit by penalties or taxes. Even though you wouldn’t be able to tell by looking at it, your Roth IRA contains 3 different types of money, each with different guidelines for withdrawing:
Contributions: The money that you personally contribute to your Roth IRA can be cashed out at ANY time for ANY reason, without penalty, taxes or fees. Whether it’s the next day, 4 months, or 39 years after you put the money in, you are free to withdraw.
Conversions: This is money that you have rolled over from a previous retirement account(such as an employer-sponsored 401k) to your Roth IRA. You can cash out this money at any time without paying TAX because it was already paid when you rolled it into your Roth IRA. However, this money may still be subject to a 10% “Early Withdrawl” fee, unless it has been in your account for over 5 years, or you are over 59 1/2.
Earnings: This is interest that your contributions have accrued while in your Roth IRA account. Although you can withdraw this money sooner than 5 years without PENALTY, you will still be assessed tax on it, because it has never been taxed (it’s like withdrawing from a traditional IRA).
Don’t Kill the Gold Goose
There are exceptions to getting around each of these criteria, but if this is the case, the very first question you have to answer is: “Why am I looking to cash out a Roth IRA in the first place?” It may be that there are alternatives to withdrawing money from your Roth that can save you money now and a lot of money in the future.
I know, this probably isn’t what you want to hear right now, but just remember that you can NEVER replace the money you withdraw. Why? Because you are only allowed to contribute a certain amount every year (which is $5,000 in 2009 & 2010). So if you have $17,000 in a Roth that you withdraw to keep yourself afloat in a crisis, and then get a high paying job 2 weeks later, you can’t just arbitrarily deposit the money back in your Roth. You could put in $5000 in 2009, put another $5000 in 2010.
Let’s say that Jimmy John Johnson has a Roth IRA account that he’s been diligently contributing to for the past 8 years. He now has about $21,000 total in the account that he is considering withdrawing for his daughter’s 1st year of college. Even if he makes the maximum contribution per year (currently $5,000), it will take him 5 years to catch back up to his 21k. Take a look at what that means in the long run:
Here are some of the most common reasons people often consider cashing out a Roth IRA:
Buying a Home
Can you cash out a Roth IRA to buy a house without penalty? Actually, yes. As part of the 1997 Taxpayer Relief Act, the Government has made provisions for Roth IRA participants to cash out a Roth IRA and withdraw up to $10,000 to buy a house. The specifics:
It must be the purchase of your first home unless you haven’t owned a home in at least 2 years. You still have to have had your Roth open for 5 years or more to avoid (Homebuying tips)Educational Expenses (financial aid, loans, scholarships)
There are no special breaks to cash out a Roth IRA for educational expenses. So any money that you withdraw for this purpose will be subject to the usual taxes and fees. Lucky for you however, when it comes to education, there are several viable options already in place for financial aid. You’d be amazed at how many scholarships and grants there are available to students of many different backgrounds.
Health Expenses (Insurance)
You should have insurance in place for the majority of your health-related expenses.
Death in the Family (Life Insurance, Estate Planning)
This is something that should be covered by insurance as well. However, if you are being financially burdened by the death of a loved one, you can cash out a Roth IRA to cover the related expenses without receiving any penalty or tax.
Consider using a traditional IRA or 401k
These resources are a good alternative because you have never paid tax on the money in there. You’re still going to have to pay tax on that money anyway.
Travel (lonely planet)
If you have a bad case of wanderlust and are itching to hit the road, you’re not alone. Fortunately, though there are several resources available to the mobile-minded Roth IRA participant so that you don’t have to deplete your hard-earned nest egg to go see the world. For starters, check out www.lonelyplanet.com
Ever heard of the United States Federal Government?
Can you cash out a Roth IRA to buy a new car?
Don’t be an idiot.
The important thing to remember when you are considering cashing out a Roth IRA is that you can NEVER replace the money you withdraw. Why? Because you are only allowed to contribute a certain amount every year.
Roth IRA Profiles
Ok so if you’re looking for the motivation to pull the trigger on this Roth IRA stuff, here are just a few words from folks who have taken the step:
Individual Profile #1
Occupation: Marketing Specialist
Life Situation: Single, No Kids, Graduated with BA, Owned my own home for 3+ years.
Financial Focus: To be able to retire in my 50′s if not earlier. Make my money work for me through investments in the stock market and property.
I have a Roth IRA through Fidelity Roth IRA
It’s been open for 9 months
It’s currently valued at $5,550
I usually contribute every month
Investment Allocation: Large Cap. Mostly domestic, and some foreign stocks.
What I like best about my Roth: I have set it up to where it deducts from my bank account automatically each month. I don’t even have to think about it and I’m doing the best thing I can with my money to prepare for the future.
If I could change anything about it: I would like to be able to contribute more than the $5,000 per year.
Advice on Roth IRAs: It is a smart investment that everyone who is eligible should have. There is no better way of investing in or protecting your future.
Other Investments: 401k, Pension Plan, Employee Stock Plan, and property.
Individual Profile #2
Occupation: Carpet Cleaning Technician
Life Situation: single, no kids, living with roommates,
Financial Focus: staying out of debt, building retirement aggressively,
I have a Roth IRA through Etrade
It’s been open for 1.5 years
It’s currently valued at $5,000
I usually contribute: monthly
Investment Allocation: Small/mid-cap, Large-cap, cash
What I like best about my Roth: Knowing it will all be tax-free down the road, allows me to dabble in the stock market, everything is online and super EZ!!!
If I could change anything about it: Increase my financial IQ of money, the stock market, and investing in general.
Advice on Roth IRAs: Just get it done early! It’s not as hard as you think.
Other Investments: Online high-interest savings account
Individual Profile #3
Occupation: Grad Student
Life Situation: Married, no kids, living on our own, taking on debt for dental school.
Financial Focus: Retirement plans, but also interested in debt-management
I have a Roth IRA through TD Waterhouse
It’s been open for 10 years
It’s currently valued at: $29,000
I usually contribute: every year
Investment Allocation: Cash
What I like best about my Roth: Takes the stress out of retirement planning, and allows me to focus on the here and now of my financial life.
If I could change anything about it: I would be more actively involved with it and look for more worthwhile investments, which would allow it to earn more money.
Advice on Roth IRAs: Get one now, the sooner the better!
Other Investments: Traditional IRA