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What Is a Roth IRA? - Definition, Rules & Benefits

Instructor: Michael Cozad

Michael is a financial planner and has a master's degree in financial services.

Explore the concept of a Roth IRA - an account that can potentially lead to tax-free growth. This lesson will define a Roth IRA and explain the associated rules and benefits.

Definition

A Roth IRA is a retirement investment account that may provide tax-free growth and distributions. The 'IRA' stands for individual retirement account. A Roth IRA can be opened by individuals with earned income of any age or by a conversion from a traditional IRA.

A Roth bears several major differences from a traditional IRA. The main differences are that contributions are not tax-deductible and that qualified distributions are tax-free. As will be discussed later, non-qualified distributions may be subject to a penalty.

Let's start with a broad example. Imagine opening an account, depositing and potentially investing some funds into stocks or bonds, and waiting until after age 59 ½, provided it's been five years since your Roth IRA was first opened, to withdraw the funds plus any growth. The complete withdrawal (including growth) can be withdrawn tax-free! This is a broad example of how a Roth IRA works.

It is important to note that investments in a Roth IRA are not limited to stocks and bonds. Other examples of what investments can be in Roth IRAs include certificates of deposit, money markets and mutual funds.

Determining Eligibility

Several factors apply in determining your eligibility to contribute to a Roth IRA, including your tax filing status and earned income. Your earned income is income generated from working. You must calculate your modified adjusted gross income, abbreviated as MAGI.

MAGI can be calculated by retrieving your adjusted gross income (AGI) from your tax return and adding items that you have deducted, such as student loan interest and tuition and fees deductions. Please refer to IRS publication 590 for a complete description of which items should be included when computing MAGI.

The chart below shows you if you can contribute to a Roth IRA, depending on your tax filing status and income:

2014 Roth IRA Income and Contribution Limits
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Rules

There are rules restricting individuals who make too much money from contributing to a Roth IRA. For example, as of 2014, if your tax filing status is single and you make over $129,000 per year, you are not eligible to contribute to a Roth IRA. The chart above provides the cut-off income if you are married and filing jointly or married and filing separately.

There are also contribution limits. The 2014 contribution limit for eligible individuals under 50 is $5,500. For eligible individuals 50 and over, the contribution limit is also $5,500, but a catch-up contribution of $1,000 is permitted for a total contribution limit of $6,500.

However, if your earned income is less than the contribution limit, your maximum contribution is your earned income. For example, if you have $2,000 of earned income, you can only contribute $2,000 instead of the maximum permitted.

It is important to note that withdrawals prior to age 59 ½ and before a five-year 'waiting period' since the Roth IRA was first established may be subject to a 10% early withdrawal penalty imposed by the IRS on the earnings portion, along with applicable federal and state income taxes. If you are considering a withdrawal from your Roth IRA prior to age 59 ½, please visit IRS publication 590, specifically, Figure 2.1, Is the Distribution from your Roth IRA a Qualified Distribution?

Benefits

Individuals that expect their income tax rate to increase in the future (specifically during retirement or at the time of withdrawal) stand to benefit the most from the Roth IRA. For many, this includes younger individuals who are in their early working years; as your income increases, typically so does your tax rate.

The tax-free growth and tax-free withdrawal are the main benefits of the Roth IRA, again, provided you adhere to the rules set forth by the IRS.

Another benefit is that you actually have 15 ½ months to contribute for a given tax year. For example, for the 2014 tax year, you can contribute and code the contribution as a 2014 Roth IRA contribution from January 1, 2014 to April 15, 2015.

Also, you are not required to withdraw funds from the Roth IRA, as you are with a traditional IRA. For the traditional IRA, this is known as the required minimum distribution.

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