Death & Taxes

Roth IRA, Part I

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By Roy Lewis

It seemed like such an easy concept when it was first introduced back in 1997: Put some money away for a while, and then take those funds and earnings out tax-free at some time in the future. But, like most tax issues, the Roth IRA has turned into a monster. While the concept might remain an easy one to understand, the actual rules and regulations have become very complex. We'll review the Roth IRA in greater detail and help make things a bit clearer. Let's get started.

You can make an annual Roth IRA contribution up to the lesser of $2,000 or 100% of "compensation" or "earned income." In general, married folks filing a joint return can make annual contributions up to the lesser of $4,000 ($2,000 each) or 100% of their combined compensation for the year.

What Qualifies as Compensation or Earned Income?
To qualify for an IRA contribution (either Roth or regular IRA), compensation or earned income is defined as wages, salaries, professional fees, and other amounts received for professional services actually rendered. It includes commissions paid to sales personnel, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, and bonuses.

Compensation or earned income does not include income from property, interest, dividends, capital gains, disability payments, social security payments, or any other form of income not included in gross income. In addition, compensation does not include any amounts received as a pension, annuity, or deferred compensation, even if it is included in your taxable income.

And, a note for all of you folks living and working on foreign soil: Earned income that is excluded from gross income under the Foreign Earned Income rules is not considered compensation for purposes of determining the amount that can be contributed to an IRA.

Finally, for you divorced folks out there, alimony (not child support... but true alimony) that you must include in your income is considered compensation for IRA contribution purposes. Therefore, if you are divorced and receive alimony, you can make an IRA contribution up to the lesser of $2,000 or your total compensation... including alimony. So, even if you had no "job," if you have at least $2,000 in taxable alimony, you are allowed the maximum contribution to a Roth IRA.

Contribution Limitations

Your total combined contributions to regular and Roth IRAs can't exceed $2,000 (or 100% of your income if you make less than $2,000) for the tax year. So, in effect, you'll want to determine which savings vehicle is best for you (Roth or regular IRA), and place that $2,000 contribution in the appropriate IRA. While the law certainly doesn't prohibit you from placing, for example, $500 in a Roth IRA and $1,500 in a regular IRA, the administrative hassles and fees might be more than you are willing to bear. But, because of the Roth IRA phase-out rules (that we'll discuss below), "splitting" your $2,000 IRA contribution into a regular IRA and a Roth IRA could be your only option if you want to make a full $2,000 contribution.

A few distinctions to pay attention to:
  1. It's important to understand that you can fund a Roth IRA and a SEP, SIMPLE, and/or Education IRA in the same tax year. The $2,000 restriction is only applicable to the combination of regular and Roth IRAs. So, if you are able to fund a Roth IRA and a SEP, SIMPLE, and/or Education IRA, the law allows you to do so.

  2. Remember also that you can fund a Roth IRA even if you are covered by a company retirement plan -- pension, profit-sharing, 401(k), etc.
Example: John is a single taxpayer. He will make $50,000 in earned income this year. John participates in his company's pension plan. Additionally, John will contribute the maximum amount to his employer's 401(k) plan. In his spare time, John has a consulting job and will earn $15,000 in additional business income (Schedule C). John will make a maximum SEP-IRA contribution based on his net business income. John also makes an Education IRA contribution for the benefit of his daughter. Even with all of these tax-deferred savings and investment vehicles, John can still make a $2,000 Roth IRA contribution for the year.

It should also be noted that any amounts converted to a Roth IRA (which we'll discuss in Part II) in a "qualified rollover contribution" are not counted towards the $2,000 annual contribution limit. So, in the example above, even with everything John had going on, he could make a "qualified rollover contribution" and still have the choice of making a $2,000 Roth IRA contribution for the year.

Income Limitations

Now for the bad news -- some individuals might not be eligible for the Roth IRA. Here are the limitations based on your tax filing status and Adjusted Gross Income (AGI):

Single and Head of Household Filers:
Income: AGI = $95,000 or less
Rule: $2,000 contribution to a Roth IRA is fully allowable (assuming that the earned income rules are met).

When AGI rises above $110,000, no Roth IRA contribution is allowable. Between the $95,000 and $110,000 "phase-out" range, only a partial Roth IRA contribution will be allowed.

Married/Joint Filers:
Income: AGI = $150,000 or less
Rule: $2,000 contribution to a Roth IRA for each of the joint filers is fully allowable (again, assuming that the earned income rules are met).

When AGI rises above $160,000, no Roth IRA contribution is allowable. Between the $150,000 and $160,000 "phase-out" range, only a partial Roth IRA contribution will be allowed.

Married Filing Separately:
For married persons filing separate returns, the AGI limitation is so severe that it virtually prohibits a Roth IRA contribution. For married/separate filers, the "phase-out" range is between $0 and $10,000. This means that a married/separate filer will never be able to take a full Roth IRA contribution and, when AGI rises above $10,000, no Roth IRA contribution will be allowed.

What the Heck is a "Phase-Out Range"?

If you fall into the "phase-out" ranges listed above, your Roth IRA contribution is limited or "phased-out" based on how far your AGI moves into the range.

Example: Jill, a single person, has an AGI of $105,000, earned income of at least $2,000, and does not participate in her employer's pension/profit-sharing plan. Since Jill's earned income is two-thirds into the phase-out range, she is only allowed a one-third contribution to her Roth IRA. Therefore, her maximum allowable Roth IRA contribution would be $666.67 (one-third of $2,000), which she can round up to $670.

Since her Roth IRA was limited, can she make a regular IRA contribution too? Sure in the amount of $1,330 ($2000 minus her Roth IRA contribution of $670). Will that regular IRA contribution be deductible? That will depend on Jill's circumstances. In our example, Jill isn't a participant in her employer's pension/profit sharing plan, so her regular IRA would be fully deductible. If she participates in her employer's pension plan, her ability to deduct her IRA contribution would also be limited. If you are unsure about the regular IRA deduction issues, check out my article on that very subject -- IRA Deduction Limitations.

You should be aware that there are no age limits on contributions to a Roth IRA. A young child with earned income can make a Roth IRA contribution if it is deemed appropriate. Not only that, unlike a regular IRA, persons older than age 70 1/2 can still make Roth IRA contributions, as long as they have earned income and are not otherwise restricted by the AGI limitations. Finally, unlike a regular IRA, a Roth IRA is not subject to the rules that require minimum IRA distributions when you turn age 70 1/2.

Remember that Roth IRA contributions for a tax year must be made no later than the due date of your tax return, not including extensions -- generally April 15th, unless that falls on a holiday or weekend. And, the mid-April date is hard and fast even if you file for an extension on your individual income tax return. Of course, you can make the contribution any time during the tax year. And, between January 1st and April 15th each year, you can make contributions for either the prior tax year, the current tax year, or both (if you will meet the AGI requirements)-- which might save you a trip next year and put your money to work sooner.

In Part II, we discuss converting a regular IRA into a Roth IRA. This is where most of the confusion still resides, so keep reading!
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