Ask MAX - Are Roth IRAs Too Good to be True?

May 24, 2004

Dear MAX,

I can't seem to find a clear description of how the tax implications work with Roth IRAs. I understand that what I put into the ROTH is never taxed. Please correct me if I am not understanding that correctly.

My confusion is in the capital gains and distribution of dividends into the ROTH account. Are gains taxed? It would seem like too much of a plus for the investor if they (gains) were not taxed. I have been to several web sites to find a clear definition of the ROTH itself before I commit to opening an account.

North Carolina

Dear Daria,

Roth IRA's have only been around since 1997, when the Senate passed the Taxpayer Relief Act. The differences between a regular IRA and a Roth IRA are significant, and choosing the one that's right for you could have a big impact on how much money you end up with in your golden years. Please keep in mind when reading this that IRAs are a concept originated by the United States Government and hence are rife with ins, outs, and what-have-yous.

Are Roth IRA's too good to be true? Well, they are pretty terrific.

Roth IRAs are a fantastic savings vehicle, because, yes, They DO allow all contributions to grow tax free. You can contribute up to $3,000 per year to a Roth IRA, and if you're over 50, you can add another $500 as a 'catch-up' contribution. These contribution limits increase to $4,000 for years 2005-2007 and then go up to $5,000 in 2008, when contribution limits will be indexed with inflation. The catch-up provision stays at $500 until year 2006, when it goes up to $1,000.

The big difference between a Traditional and a Roth IRA has to do with how the money you put in and take out is taxed.

The money you put into a regular IRA is tax deductible, while that which you put in a Roth IRA is not. So if, for example, you make $30k a year and you put $3k in a regular IRA, come April 15th you would only pay income tax on $27K. If you put $3k in a Roth IRA, you pay income tax on your entire salary. Roth IRA contributions are never tax deductible like they could be with Traditional IRAs. That's because your distribution that you will eventually take is designed to be tax free.

Conversely, the money you pull out of a Roth IRA isn't taxed, while the money you pull out of a traditional IRA is. A distribution form a Roth IRA is not included in your income if it is a "qualified distribution" or if it is a return of your original contribution.

What's a "qualified distribution"?

For a distribution to be qualified, it must satisfy both of the following tests (bear with us, this gets a little technical):

1. The distribution must be made after a 5-taxable-year-period- which begins January 1st of the taxable year you make a contribution. So, if you make a contribution for the taxable year 2001, whether you actually write the check in 2001 or just in time to make the income tax deadline on April 15th of 2002, your 5-year clock technically starts on January 1st of 2001. Thus a qualified distribution could technically be taken as of January 1st of 2006.

2. In addition to the five-year test, the distribution must satisfy one of the following requirements:

a) made on or after the date on which the owner attains age 59 1/2, or
b) made to a beneficiary or estate of the owner on or after the date of the owner's death, or
c) is attributed to the owner being disabled, or
d) for a first-time home purchase (subject to a $10,000 life time limit)

So, if your adjusted gross income allows you to contribute to a Roth, and you meet these tests when you're ready to withdraw all or part of your money, it is ALL tax free and penalty free- capital gains, earnings, and all!

One additional and oft-overlooked benefit of Roth IRA's is that if you need to withdraw ROTH IRA money for education expenses, and it doesn't meet the "qualified distribution" tests above, you will have to pay taxes on the earnings only, but you avoid the 10% penalty on the earnings.

Unfortunately, not everyone is permitted to contribute to a Roth IRA. For starters, you can make full contributions to a Roth IRA only if you are a) single and make less than $95,000 a year or b) married and you and your spouse collectively make less than $150,000 a year (partial contributions are allowed if you're in what's called the "phase out range": $95-110K for singles, $150-160k if you're hitched.) You can put money in a regular IRA no matter how much money you make.

Thanks for the question.


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