The Roth IRA Rules

As promised in my earlier post, we are going to look at the rules that govern the Roth IRA today. I had read this article some time back and the following text really stuck in my memory:

If a 25-year-old contributes $5,000 each year until she retires and makes an average annual return of 8% on her investment, she’ll have $1.4 million saved by the time she retires at age 65. And the money is all hers — she won’t have to give the IRS a cent of it if she waits until retirement to cash out.

This sounded really good, but it is worth remembering that there are no guarantees of earning 8% annually.

I decided to do some spade work and see how the Roth IRA really works and what the rules are that govern it. There are quite a few eligibility criteria that determine whether you can or cannot enjoy the benefits of a Roth IRA. While there are a lot of upshots, there are some limitations as well.

Distribution/Withdrawal Rule

Like I said in my earlier post, contributions made to your Roth IRA are not tax deductible and if you wait until after the date you reach the age 59 and a half, you don’t pay anything back in way of tax when you take out the money. This is also subject to your having had your savings in your Roth account for a minimum of 5 years. Early withdrawals are generally subject to a 10 % tax. There are, however several exceptions to this rule of 10% tax on withdrawal: this includes certain disabilities, higher education expenses, or if you are a first time homeowner, etc.

The Phase-Out Rule

You qualify to contribute to your Roth account if you fall within certain income brackets. If you are single, and earn less than $99,000 (the sum for married persons filing jointly is $156,000 in this instance) a year, you can make the maximum contribution. Then the amount you may contribute reduces, or is phased out as your income increases. If you earn more than $114,000 (or $166,000 if married and filing jointly) a year, then the permissible contribution becomes zero, i.e. phased out. These limits are increased by $2000 ($3000 if married and filing jointly) for the year 2008. So this is the phase out rule of the Roth IRA. If however your income rises above the amounts mentioned above, your balance in the Roth account remains sheltered from tax.

Maximum Contribution Rule

There is a ceiling on how much money you can deposit into your Roth account each year. You can deposit up to $4000 for the year 2007 and $5000 for the year 2008. If however you are above 50 years of age, then under the catch-up provision you can contribute an additional one thousand a year ($5000 and $6000 for the respective years of 2007 and 2008). Beyond 2007 this limit will be revised subject to the inflation index.

Eligibility Rule

There is no age limit or minimum required age to make a Roth contribution, any child with earned income can make it and a person can do so even over the age of 70 and a half, provided they have an earned income.

Stay tuned for more on the Roth IRA in upcoming posts.