How does a Roth IRA work

What is a Roth IRA

IRA is an Individual Retirement Account that a person can choose to set up with a financial institution. The purpose of creating an IRA is to stash away money for retirement and avail a few tax breaks. Generally, depending upon when one would prefer paying taxes, one can choose between the Traditional IRA or the Roth IRA. The Roth IRA was set up under the Taxpayer Relief Act of 1997. Setting up a Roth IRA is an easy step. The hard part is dealing with issues like contribution, distribution and off course rollovers. In case of a Traditional IRA the contributions are tax deductible and one pays taxes at the time of withdrawal. While in case of a Roth IRA the contributions are not tax deductible.

Contributions to the Roth IRA

The limits on contribution to a Roth IRA depend on whether a person is married and filing jointly, married and filing separately or whether the person is single. Accordingly the limits for contribution are decided on the basis of the MAGI (Modified Adjusted Gross Income). The amount that a person can contribute can be found in the IRS Publication 590 (2008). The publication also covers some new rules for 2009. Age is no constraint when it comes to contributing to Roth IRA. Anybody who has an earned income can make a contribution to the Roth IRA, as long as their MAGI is within limits. Again there are no age limits as far as contributions are concerned.

Can we rollover 401(k) to Roth IRA?

Even if a person is covered under 401(k) he can still contribute to the Roth IRA. However, one cannot directly roll over a 401(k) to a Roth IRA. Rolling over a 401(k) essentially means that a person converts his 401(k), into an investment he deems appropriate. Rolling over a 401(k) is generally considered when people change jobs. On changing employers, a person has the right to take his money from the 401(k) plan and invest it. He also has the option of leaving his money with his old employer, if he has more than $5000 in his 401(k). Since one is not allowed to contribute to the former employer's 401(k), this is not a good idea. The best course of action would be to rollover the money from the 401(k) to a Traditional IRA. Traditional IRA forces a person to start withdrawing after the age of 70 ½, hence one can rollover from the Traditional IRA to the Roth IRA, since in case of the latter withdrawals are not mandatory.

Distributions from a Roth IRA

A distribution is the term given to withdrawals. Any withdrawal from the Roth IRA is qualified for a tax exemption provided it meets the following conditions. Such a withdrawal is also known as a qualified withdrawal:

• The withdrawals should be made on or after the age of 59 ½
• Or a maximum amount to the tune of $10,000 can be withdrawn for the purpose of buying a first home
• Or withdrawals are allowed if one becomes disabled
• Or if one dies, the beneficiary is entitled to the money

Even if all these conditions are met one might not be eligible to withdraw, in case five tax years have not elapsed since the investor stashed his money in the Roth IRA. A person is allowed to have more than one Roth IRA. In this case the five year period will start with the first Roth IRA that was established. One must remember that 5 tax years are not always the same as 5 calendar years.

A Roth IRA provides many benefits to a person who intends to save for retirement. However one should read the rules and regulations that govern the contributions and distributions before investing.