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You are here: Home / Archives for Traditional IRA

The Roth IRA – Like Ice Cream, But in the Tax World

March 27, 2012 by Average Joe 7 Comments

Today’s post is part of a larger effort in the personal finance community to discuss Roth IRAs. Congratulations to Jeff Rose of Good Financial Cents for organizing such an effective Roth IRA movement day.

 

I remember when I was maybe nine. My dad FINALLY let me order my own banana split at the local Tastee-Freeze.

I’d watched him down banana splits with pride. First he’d take care of the cherry and whipped cream. Then he’d cut into the bananas and shovel them into his mouth along with heaping helpings of three big scoops of ice cream.

At age nine I was firmly convinced that more = better in the world of ice cream.

More = better with retirement accounts also, and the Roth IRA is like the banana slices along the side of those three big piles of ice cream.

Some of you may be thinking, “why isn’t the Roth IRA those three wonderful scoops of ice cream?” ….or maybe “how come it isn’t the cherry on top of the whole thing, like the crown jewel?”

The answer is simple: there are other ways to save, and the Roth IRA goes better along with them than without. In other words, you can have a banana or you can have ice cream.

The Roth IRA allows you to eat your bananas with ice cream on the same spoon. Confused yet? So am I, so let’s move on. I’ll explain that later.

 

What is a Roth IRA?

 

A Roth IRA is a tax shelter available to US taxpayers. Unlike a Traditional IRA, which gifts the possibility of a tax break today, Roth IRA contributions don’t help your current tax situation. Instead, Roth IRA money is distributed for your later goals on a tax free basis, assuming you follow some fairly simple IRS rules.

 

How Much Can I Contribute?

 

Roth IRA contribution amounts change yearly, so it’s best to consult the IRS website for the official answer to this question. Use Google or Bing to search “Roth IRA Contribution Limits (YEAR) .gov” and you’ll find the site. Here’s the most current page at the time of writing.

Persons over age 50 are allowed to make additional contributions above those persons who are younger. These are commonly referred to as “catch up” provisions.

 

Are There Income Limitations?

 

Yes, there are. As with contributions, income limits change often, so it’s best to consult the IRS website for these details.

In general, there is a top amount of money you’re allowed to earn each year and still make full contributions. Then, there is a phase-out income zone. If your income falls in this zone above the full contribution limit, you may contribute, but not the full amount.

Finally, people earning above the phase-out zone are not allowed to contribute to a Roth IRA. However, you may use a conversion Roth IRA tactic that we describe in detail in another piece. See: Help! I Make Too Much Money to Contribute to a Roth IRA!

 

What Type of Investments Are Available?

 

You can invest in nearly any type of investment, but most people stick with the basics: stocks, bonds, mutual funds, exchange traded funds, and certificates of deposits.

While it’s possible to invest in actual real estate property or actual pieces of precious metals, there are complicated rules around these investments and you should consult with experts who are knowledgeable in these areas before trying to invest.

 

When Can I Withdraw Funds?

 

The Roth IRA has different rules for your contribution and the interest your account earns.

Your contribution may be withdrawn at any time, without penalty. We discuss this in detail in this piece. See: Emergency Fund or Roth IRA?

The interest the account earns must stay in the account until you’re age 59 1/2 or older. At that time, you may remove interest without penalty as long as the money has been in the account at least five years.

You may also remove money for other goals pre-59 1/2, such as a first time home purchase or for qualified college expenses. In these cases, funds aren’t considered tax free, but are only tax deferred. However, you do have the flexibility to save for goals other than college without worrying about dividend interest or capital gains taxes.

 

Can I Change Existing IRA Accounts Over to a Roth IRA?

 

Sure. However, these accounts have different rules. Here’s a link to the IRS website which explains Roth Conversion IRAs.

 

Why is a Roth IRA Like the Banana?

 

Remember how I mentioned that my dad would spoon some Roth IRA into his mouth along with some of the ice cream?

When I finally was allowed to order my own banana split, I learned the magic: bananas and ice cream are flippin’ awesome together.

People ask all the time which is better, a Roth IRA or a Traditional IRA or 401k plan? My answer is this: it isn’t about one or the other. Traditional IRA plans and 401k plans give you nice tax breaks today. You should utilize those. But a Roth IRA gives you healthy tax breaks and flexibility down the road.

Because we don’t know what tax brackets are going to look like in the future, a Roth IRA allows you to hedge your bet on tax brackets and instead have plenty of options later.

 

How Do I Maximize My Roth IRA Contributions?

 

Because you’re allowed to change Roth IRA contributions back out, there are strategies which can take advantage of possible market fluctuation during the year. Here’s one such strategy: Your Roth IRA Conversion: Super-Sized

 

(photo credit: Gabrielsaldana, Flickr)

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Filed Under: Retirement, successful investing, Tax Planning Tagged With: Individual Retirement Account, IRS, Roth, Roth IRA, Traditional IRA

HELP! I Make Too Much Money to Contribute to a Roth IRA…Now What?

March 13, 2012 by The Other Guy 22 Comments

First of all, you make how much money?

Congratulations!

If you make so much money you can’t contribute to a Roth IRA, then a certain amount of back slapping and high-fiving are in order.

If you need a refresher on the Roth IRA limits to determine if you can contribute, we’ve got your back:

If You Have Taxable Compensation and Your Filing Status Is… And Your Modified AGI Is…

Then…

married filing jointly or qualifying widow(er)

Less than $173,000

you can contribute up to the limit.

at least $173,000 but less than $183,000

the amount you can contribute is reduced.

$183,000 or more

you cannot contribute to a Roth IRA.

married filing separately and you lived with your spouse at any time during the year

 zero (-0-)

you can contribute up to the limit.

 more than zero (-0-) but less than $10,000

 the amount you can contribute is reduced.

 $10,000 or more

you cannot contribute to a Roth IRA.

single, head of household, or married filing separately and you did not live with your spouse at any time during the year

less than $110,000

you can contribute up to the limit.

at least $110,000 but less than $125,000

the amount you can contribute is reduced.

$125,000 or more

you cannot contribute to a Roth IRA.

Information courtesy of the IRS 

A couple things to point out in our table above:

– First, don’t think just because you make a lot of money and your spouse doesn’t that you can just file “married and separate.”  The IRS thought you might consider that maneuver, and now caps income at $10,000 for those who consider that loop-hole.

Also, be aware of what “Modified” AGI means.  Leave it to the government to complicate an already complex issue.

Here’s how you calculate your “Modified” AGI (also courtesy of the IRS)

Modified AGI.   Your modified AGI for Roth IRA purposes is your adjusted gross income (AGI) as shown on your return modified as follows.

  1. Subtracting the following.
    1. Roth IRA conversions included on Form 1040, line 15b; Form 1040A, line 11b; or Form 1040NR, line 16b. Conversions are discussed under Can You Move Amounts Into a Roth IRA, later.
    2. Roth IRA rollovers from qualified retirement plans included on Form 1040, line 16b; Form 1040A, line 12b; or Form 1040NR, line 17b.
  2. Add the following deductions and exclusions:
    1. Traditional IRA deduction,
    2. Student loan interest deduction,
    3. Tuition and fees deduction,
    4. Domestic production activities deduction,
    5. Foreign earned income exclusion,
    6. Foreign housing exclusion or deduction,
    7. Exclusion of qualified bond interest shown on Form 8815, and
    8. Exclusion of employer-provided adoption benefits shown on Form 8839.
Here’s the point: Knowing your Modified AGI is not as simple as just looking at your W2 to figure out if you’ve made too much money.
If you haven’t done your taxes yet, Turbo Tax or HR Block software will help you find this amount automatically.
Let’s assume–after all these funky calculations–that it’s true: you’ve earned too much money.
Here’s some good news: You, Mr. or Ms. High Wage Earner, still can contribute to a Roth IRA.
You just have to do it the right way.  Luckily for you, I’m going to show how:
  • First, open a non-deductible IRA at your favorite brokerage house (Fidelity, E-trade, Schwab, etc.).
  • Next, fund your non-deductible IRA up to your maximum IRA contribution limit ($5,000 for those under 50; $6,000 for those turning 50 in the tax year of the contribution);
  • Wait at least 30 days, or a statement cycle so you can show the money was in an IRA  – *DO NOT INVEST YOUR MONEY DURING THIS 30 DAY WAITING PERIOD;
  • Then, call your brokerage firm and perform a Roth IRA Conversion of your IRA money.  You’ll owe tax on the gain (probably just a couple cents of interest), but other than that…pretty easy!

You’ll likely have to fill out a special tax form next year (IRS Form 8606) discussing the conversion, but there will be no tax, no penalty, and now you have a Roth IRA.

A couple of rules:

  1. If you have other IRA money (other than the $5,000 you just put in), you cannot just tell the IRS you want to convert the non-taxable kind.  You have to convert IRAs pro-rata which mean only a percentage of your money will be tax free.  If you have other IRA money (not 401(k) money, IRA money), before embarking on this strategy – discuss this with a knowledgeable tax advisor who knows what they’re taking about.
  2. Unlike a normal Roth IRA contribution, you do not have immediate access to these dollars.  You can access them after 5 years – just like any other conversion monies.
  3. Don’t tempt fate and try to do this at the end of a tax year.  There are too many chances for last minute screw-ups.  Complete this process during the middle part of the year so you have plenty of time to fix problems before the year’s over.  The IRS doesn’t like multiple 1099 forms and stuff like that…as an aside, neither does your accountant.

So there…badaboom, badabing.  Now even the 1%-ers can have a Roth.  Just like Congress intended.

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Filed Under: Planning, successful investing, Tax Planning, tax tips Tagged With: Adjusted gross income, Individual Retirement Account, Internal Revenue Service, Modified AGI, Roth, Roth IRA, too much money, Traditional IRA

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