A Roth IRA is where you cannot make tax deductions because your contributions are supposedly be made with after-tax dollars. Usually when you get your paycheck, a portion of it went to taxes. What's ever left over is yours and you can put this in the Roth IRA. Since you cannot make tax deductions, any withdrawals you make after age 59 1/2 are tax free. Tax free withdrawals are generally not allowed within the first 5 years beginning with the first tax year contributions and conversions. For example, lets say you contribute $1000 into the Roth in 2006. The 5 year holding period on the earnings began on January 1, 2006 and expires on December 31, 2010. Lets say that a year later, you convert your Traditional IRA into a Roth IRA on March 1, 2007. The 5 year holding period begins on January 1, 2007 and ends on December 31, 2012 on all earnings from the conversion.
I also heard that you can withdraw your contributions anytime without paying income taxes or penalties. I asked that question to a tax expert at Kiplinger and he said "Roth contributions can be withdrawn at anytime, tax- and penalty-free, regardless of your age." According to IRS publication 590, under subheading Roth IRA, title "Are Distributions Taxable?", it states "You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s)." In other words, you can withdraw your contributions anytime without paying income taxes or penalties.
Not everyone can get a Roth IRA. If you are single and your adjusted gross income (AGI) is above $120,000, you cannot get a Roth IRA. If you are married and filing jointly (or qualify widow(er)) and your AGI is above $177,000, you do not qualify for a Roth IRA. If you are married, but filing separately, and the spouse lives with you, you do not qualify for a Roth IRA if your AGI is above $10,000. (These figures are for tax year 2011. For up to date figures, go see IRS Publication 590).
When you make withdrawals from your Roth IRA, you may or may not pay taxes. You should know that the IRS does not prohibit you from withdrawing money. You can make withdrawals at anytime, but you may pay a penalty and possibly income tax. When you take distributions or make withdrawals, this is how your distributions are paid out in this order:
1) Your annual contributions. You can withdraw this at anytime without penalty or taxes.
2) Taxable portion of first rollover (the conversion). This only applies if your lifetime withdrawals exceeds your lifetime contributions. If you make withdrawals on this portion before age 59 1/2, you will pay a 10% penalty.
3) Non-taxable portion of first rollover. This only applies after the taxable portion of rollover has been withdrawn. You will pay no taxes or penalties on this portion at anytime.
4) Each subsequent rollover, in order, with the taxable portion coming out first and then the non-taxable.
5) And finally, any earnings. If you get to this point, you will pay income taxes during the 5 year holding period. If withdrawn before age 59 1/2, you will pay a 10% penalty, unless it was a qualifed withdrawal. See Age 59 1/2 Rule. After age 59 1/2 and after the 5 year holding period, you do not pay any taxes on the earnings.
Things to remember about Roth IRAs
1) Not everyone can get a Roth IRA. It depends on your Adjusted Gross Income and filing status.
2) None of your contributions are tax-deductible, but when you withdraw your contributions, they are tax-free and penalty-free.
3) Your withdrawals after age 59 1/2 may be tax-free.
4) You must hold the earnings and any conversions in your Roth IRA for 5 full tax years in the beginning.
Some questions I get:
Q1: What if I open my first Roth IRA at age 60, does the 5 year holding period still apply?
A1: Yes, but you can withdraw your contributions at anytime without paying any taxes.
Q2: If I open another Roth IRA somewhere, does the 5 year holding period apply?
A2: 5 year holding period only applies to your first Roth IRA.
Q3: If I convert or rollover my Traditional IRA into a Roth IRA, what should I know before doing this?
A3: One, you will pay income tax on the earnings and any part of your contributions you made tax-deductible. Second, you have to move the entire balance into the Roth IRA within 60 days of receiving receipt. Third, the 5 year holding period will apply on this conversion, whether you previously have a Roth IRA or not.
