Roth IRA

Roth IRA

Host : We're back here with David Luhman discussing recent changes to IRAs and other aspects of the new tax law. You say there are a number of changes with traditional IRAs, but what's the story behind the new type of IRA?

David : The new IRAs are called Roth IRAs after the Senate Finance Committee chairman who championed them. Roth IRA's are basically the inverse of a traditional IRA.

Host : How's that?

David : With a traditional, deductible IRA, you get a tax deduction on the front end, when you contribute to the account, but you face ordinary income tax rates on the back end when you withdraw money.

However, with a Roth IRA, you get no immediate tax benefit when you contribute to the account, but you face no tax when you make qualified withdrawals. Or at least that's the way it's supposed to work.

Host : Why do you say "supposed to work"?

David : Let's look at the example of Social Security. Originally, all income you received from Social Security was supposed to be tax free. And it worked this way for about 50 years. However, they changed the rules on us in 1983, and again in 1993.

Now, if your income is as low as $25,000, your Social Security benefits are taxed.

Also, take a look at supposedly tax-free municipal bonds. Because of a wonderful 1980s invention called the "modified AGI", municipal bond holders effectively are taxed on their income.

Host : But Roth IRA withdrawals aren't subject to tax, right?

David : Right. I'm just doing a little pessimistic speculation here. Qualified Roth IRA distributions aren't subject to income tax, and you should presume they'll be tax-free going forward. But I wouldn't put anything past our politicians.

Host : You said "qualified" withdrawals aren't subject to tax. What makes a withdrawal "qualified"?

David : Like anything with taxes, a qualified withdrawal isn't an easy concept. First, you basically need to have money in your Roth IRA for at least 5 years.

After that, any withdrawal after age 59.5 is tax-free. You also can withdraw your original contributions at any time without paying any taxes.

The IRS works on the assumption that you make withdrawals from contributions first, and then withdrawals from earnings come second. This works to your advantage.

You also can make penalty-free withdrawals from your Roth IRA if you become disabled, buy your first home or pay for college. Your beneficiaries also can make penalty-free withdrawals after your death.

If you're under age 59.5, these may be penalty-free, but you'll face income taxes on distributions of earnings. Roth IRA contributions can be withdrawn free of penalties and taxes at any time, unlike traditional IRAs.

Host : So this sounds like a Roth IRA is more flexible than a traditional IRA.

David : Yes, I'd say so. Also, with a Roth IRA if you have earned income you can make contributions after age 70.5, unlike a traditional IRA. You also don't have to make required minimum distributions after age 70.5 like you must do with a traditional IRA.

Host : Are there any phase-outs associated with a Roth IRA?

David : Yes. If you're single and your income is above $95,000, your ability to contribute is phased out. Couples face a phase-out at $150,000. But these are quite high, so almost everyone can contribute to a Roth IRA.

Host : Can I have both a traditional IRA and a Roth IRA?

David : Sure. If you have at least $2,000 in earned income, you can put any combination of $2,000 into a traditional IRA and a Roth IRA. For example you could put $1,500 into a Roth IRA and $500 into a traditional IRA.

Of course you need earned income here, unlike an education IRA where there's no requirement for earned income. If you have no earned income because you're a student or retiree, you can't contribute to a traditional or Roth IRA.