Why Should Young People Invest in a Roth IRA?

If you follow the Roth IRA Rules, any contributions you make towards a Roth IRA will grow tax-free for years to come, and with the power of compound interest, your money will grow at even a faster pace! Upon retirement, you will NOT have to pay taxes on your Roth IRA earnings as well. Furthermore, Roth IRAs allow you to invest in many different investments such as Bonds, Stocks, Real Estate, Derivatives, Mutual Funds and more.

A Roth IRA account can be opened until April 17th of the current tax year, and contributions can made starting from the previous year. The current maximum Roth IRA limit for 2006 is $4000. From 2010, the maximum Roth IRA contribution limit will rise to $5000.

Compound Interest & Roth IRA?

If a young saver at the age of 25 invests $4000 a year into a Roth IRA and earns 8% a year on his investment, he will have a huge nest egg of $1.1 million upon retirement (at the age of 65). What’s more, none of this $1.1 million nest egg is taxable upon retirement!

Consider a contra-example scenario. If that same 25 year old young saver invests $4000 a year into a regular taxable savings account earning 8% interest, he would grow a nest egg of $800,000 upon retirement (at the age of 65) – assuming a 15% tax rate.

Characteristics of a Roth IRA Account

  • Distributions or Withdrawals on your contributions from a Roth IRA account can be taken out at any time without incurring the 10% early withdrawal penalty fee in 401k accounts, as well as no taxes payable.
    Note: A Roth IRA is meant for saving towards retirement and withdrawals from your retirement savings account are always discouraged (unless for emergencies and unexpected circumstances).
    Note: Also note that withdrawals from your Contributions are non taxable. However, any earnings you have made on those contributions (such as the 8% interest earnings) is taxable at your local state & federal taxes and subject to 10% early withdrawal penalty fee (if withdrawn before the age of 59 and 1/2).

ReCharacterization of IRA Contributions or Roth Conversions

Recharacterization is when a 401k participant switches from a Traditional IRA plan to a Roth IRA plan, and due to various # of reasons, switches back to the Traditional IRA plan. When making IRA recharacterizations, individuals have to calculate their earnings and losses on the original value of their Roth Conversions or IRA contributions. It is imperative that these earnings/loss calculations are done correctly otherwise the tax consequences can be severe.

First, the deadline for Recharacterization of a Roth Conversion of IRA Contribution is your tax-filing deadline (April 15th of each year). However, you are eligible to receive a 6 month extension on Recharacterizations which means your deadline is Oct 15th of each year. For example, if you want to Recharacterize a 2004 IRA contribution you made, your deadline is October 15th, 2004.

Why Would I want to Recharacterize my Roth Conversion?

A taxpayer can choose to recharacterize his Roth Conversion for reasons such as:

  • Previous Roth Conversions were ineligible and failed
  • Value of retirement assets have decreased since the Roth Conversion*
  • Individual has a change of mind and wants to switch back to a Roth IRA

* For example, when Roth IRA assets are converted, the taxable amount of the conversion is the initial value when the assets are converted, even if these assets have declined in value. For instance, if a taxpayer converted his IRA assets worth $120,000 in April of 2004, and these assets have since decreased in value to $40,000, the individual will still have to pay taxes on the initial $120,000 he deposited in April of 2004. Who said tax rules are fair!?

Why Would I want to Recharacterize my IRA Contribution?

A taxpayer can choose to recharacterize his IRA Contribution for reasons such as:

  • An individual can recharacterize his Traditional IRA contributions into Roth IRA contributions due to tax-free accumulation and accrual of earnings.
  • An individual can recharacterize his Roth IRA into a Traditional IRA in order to be eligible to make tax deductions on the amount.

How Do I Recharacterize my Roth Conversion of IRA Contributions?

In order to recharacterize your IRA, you must move all the retirement savings and assets from the original IRA into your new IRA plan. Your financial institution can simply do this move by changing the type of IRA, for example from a Traditional IRA into a Roth IRA. Check with your financial institution as to their requirements, plus all the documentation you will need to successfully recharacterize your IRA.

Differences between Traditional IRA & Roth IRA – 8 Exceptions to the 10% Early Withdrawal Penalty

Interestingly, there are 11 different types of IRAs ranging from Individual Retirement Accounts, Employer and Employee Association Trust Account, Spousal IRAs, Rollover Conduit IRA, etc. The most common are the traditional IRAs and the Roth IRA. In this article, we will explain the differences & similarities between the two.

Traditional IRA

In Traditional IRA, the contributions you make towards the account are not taxed. Whatever capital gains & earnings you make on your IRA are also not taxed up until retirement, when you withdraw money from your account. For example, imagine you made $50,000 this year and contributed $5000 to a traditional IRA. You will be taxed on $50,000 – $5000 = $45,000. Furthermore, your $5000 contribution will grow tax-deferred for many years, until you retire and decide to withdraw it. The setback with this is that your $5000 (which would have probably grown to $50,000 upon retirement) will then be taxed at your ordinary income tax rate.
Note: You can only withdraw this money after you turn 59 and 1/2 years or older. Any withdrawals made before this age will be subject to income taxes as well as a 10% early withdrawal penalty. However if you use the withdrawn funds to finance higher education expenses or for the below list of 8 exceptions, you will not have to pay the 10% early withdrawal penalty.

8 Exceptions that Eliminate the 10% Early Withdrawal Penalty

There are 8 exceptions to the 10% early withdrawal penalty (i.e. withdrawals that are taken before the age of 59 and 1/2). They are for distributions that:

i) Are taken because of the IRA owner’s disability

ii) Are taken because of the IRA owner’s death

iii) Are a series of loan repayments made over the life expectancy of the IRA investor

iv) Are used to pay for unreimbursed medical expenses that exceed 7.5% of the adjusted gross income of the IRA owner

v) Are used to pay for medical insurance premiums if the IRA investor has been unemployed for more than 12 weeks

vi) Are used to pay for the purchase of a principal residence (maximum of $10,000 can be withdrawn). Also, the IRA investor must not have previously owned a home within the last 24 months.

vii) Are used to pay for higher education expenses of the IRA owner or eligible dependants/family

viii) Are used to pay back taxes of an IRS levy placed against the IRA

Traditional IRAs are commonly associated with the old way of investing: certificates of deposits. This stereotype is because most banks sell CDs and they are the ones that offer Traditional IRA accounts for investors. But remember, you are not limited to investing Certificates of Deposit or bonds only, you can make higher risk investments such as cyclical stocks, commodities, futures, ETFs, etc.

What Is an IRA (Individual Retirement Account)? – Introduction, Contribution Limits, Early Withdrawal Penalties, Advantages/Disadvantages

Also known as an Individual Retirement Arrangement, an IRA is a retirement savings plan available to anyone who receives taxable employment income or compensation in a given year. Examples of taxable income include wages, salaries, bonuses, taxable alimony, commissions, fees & tips. An individual can have multiple IRA accounts but the total contribution limits are outlined in the table below.
Note: An individual’s IRA contribution is limited to the lesser of total taxable compensation, or the normal annual contribution limits, whichever is lower.

Year Regular Contributions Catch Up Contributions
2001 $2000 $0
2002 $3000 $500
2003 $3000 $500
2004 $3000 $500
2005 $4000 $500
2006 $4000 $1000
2007 $4000 $1000
2010 $5000 $1000
2009 $5500 $1000

Beginning in 2009, annual IRA contribution limits will increase by $500 adjusted for inflation. All contributions to an IRA are tax-free until withdrawn at the age of 59 and 1/2. Any withdrawals made prior to that are subject to a 10% early withdrawal penalty as well as income taxes owing. There are 8 exceptions to this, see the 8 exceptions below.

Traditional IRA contributions may or may not be tax deductible depending on the tax filing status of the investor. This also depends on the adjusted gross income (AGI) and eligibility to participate in a qualifed IRA retirement plan. Deductibility of contributions becomes zero if the IRA investor’s income falls in between these adjusted gross incomes (AGIs).

Year Filing as Single Filing as Joint
2001 $33,000 – $43,000 $53,000 – $63,000
2002 $34,000 – $44,000 $54,000 – $64,000
2003 $40,000 – $50,000 $60,000 – $70,000
2004 $45,000 – $55,000 $65,000 – $75,000
2005 $50,000 – $60,000 $70,000 – $80,000
2006 $50,000 – $60,000 $75,000 – $85,000
2007 $50,000 – $60,000 $80,000 – $100,000

A working spouse who is not enrolled in employer sponsored IRA can make a tax-deductible contribution of a maximum of $2000 to an IRA each year, even if the other spouse is enrolled in an employer sponsored IRA. When the couple’s combined adjusted gross income reaches $150,000, tax deductibility for such contributions lowers. At an AGI of $160,000, it becomes $0!

Making Roth IRA Contributions – Single, Head of Household and Married Filing Joint – Eligibility & Examples

Making Roth IRA contributions has gotten ever more complex with increased rules & regulations that control your contribution limits, eligibility, modified adjusted gross income, etc. In this article, we will explore Roth IRA contributions in greater detail and compare them with making contributions to other IRAs.

A Roth IRA investor can make an annual non tax-deductible contribution to a Roth IRA that may not exceed

i) the maximum Roth IRA contribution limit set by the IRS or

ii) 100% of the individual’s earned income for the year


iii) the sum of all contributions to all other individual retirement plans for that year (other than an Education IRA).

Do you see how a simple Roth IRA concept can get so complicated? Let’s explain these clauses. This means that the total contributions you make towards both a traditional IRA and a Roth IRA cannot exceed the defined contribution limit for that year. It is therefore better to pick only 1 out of the two options; traditional IRA or Roth IRA and make the total allowable contribution to it. For example if John has $5000 to contribute towards his IRAs, he would be better off putting all the $5000 to a Roth IRA, as opposed to contributiong $1500 to a traditional IRA and $3500 to a Roth IRA. This eliminates the administrative costs of maintaining & signing up for two different retirement programs, as well as broker fees, etc.

Here are 2 important notes to remember about Roth IRA contributions:

i) You can contribute to a Roth IRA and a Simple/SEP/Education IRA at the same time. The annual contribution limit to IRAs is applicable only to traditional & Roth IRAs; not the Simple/SEP/Education IRAs. Therefore if you have the money to make 100% of allowable contributions to a Roth IRA as well as a Simple or SEP or Education IRA, then by all means you can do so!

ii) You can contribute to a Roth IRA even if you are already enrolled in a company sponsored 401k/profit sharing plan.


Consider Mohammed who is a programmer and earns $60,000 a year. Mohammed contributes to his employer sponsored 401k plan as well as the company’s pension plan. In his spare time, Mohammed runs an auto detailing shop from his basement that nets him an extra $10,000 a year. Mohammed will therefore make an SEP IRA contribution based on his net business income. Mohammed also contributes to an Education IRA for the benefit of his son, Ahmed. The beauty of Roth IRAs is that despite of all these contributions to a 401k, SEP IRA and an Education IRA, Mohammed can contribute a further $5000 to a Roth IRA for the year 2010. This is because $5000 is the total allowable contribution that can be made to a Roth IRA in 2010.

Note: A qualified rollover contribution to a Roth IRA does not count in the maximum annual contribution limit. In the example above, Mohammed could make a qualified rollover contribution from his SEP IRA to his Roth IRA and that amount would not count as part of the $5000 contribution limit; meaning MOhammed could contribute an additional $5000 on top of his qualified rollover contribution. Beauty!

Roth IRA Conversions – Eligibility, Types of Conversions and Adjusted Gross Income Limits

The Roth IRA is a better choice than traditional IRA because contributions are made after-tax adding greater tax leverage to your retirement savings allowing you to grow your savings tax-free and withdraw them tax-free! What happens if you already have a traditional IRA and would like to convert it to a Roth IRA? This is where Roth IRA conversions come into play!

Qualified Roth IRA Conversion

In order to successfully convert a traditional IRA to a Roth IRA, the conversion must be ‘qualified.’ Roth IRA conversions are treated as rollovers at all times, regardless of the method used. There are 3 of these methods, discussed below:

i) Rollover – You can take a distribution from a traditional IRA and roll it over to a Roth IRA within 60 days. To meet the 60 day rule, count the day you receive the check and include the day when you deposit the money into your Roth IRA. For example if you get the check on April 1st, 2010, you must have it deposited by May 30th, 2010. There is no extension granted for holidays and weekends.

ii) Trustee-to-trustee transfer – You can instruct the trustee of your traditional IRA to make a direct payment to the trustee of your Roth IRA. This is also considered a qualified rollover.

iii) Same-trustee transfer – If you have only 1 trustee for both your traditional IRA and your Roth IRA, you should instruct the trustee to transfer directly from traditional to Roth IRA.

Adjusted Gross Income Limits

The law states that if your adjusted gross income (AGI) is greater than $100,000, you cannot convert from a traditional IRA to a Roth IRA. This law applies to both singles, married filing joint & head of household filers. Note that if you are filing a married-filing-separate tax return, you are not eligible to convert a traditional IRA to a Roth IRA at all, no matter what your adjusted gross income is.

An interesting question asked is, what if you made a Roth conversion last January and find out that your adjusted gross income will exceed $100,000? If this happens, there is nothing to worry about. You can convert your Roth IRA back to a traditional IRA via a few simple procedures known as IRA Recharacterizations.


John has an AGI of $85,000. He also has a traditional IRA of $55,000 that he would like to convert to a Roth IRA. John’s official adjusted gross limit (AGI) threshold for the year would be $85,000. Note we do not include the $55,000 conversion in the AGI limit because the law forbids that.

Taking Qualified Roth IRA Distributions – Eligibility & Examples

Any ‘qualified distributions’ you take from a Roth IRA will NOT be included in your taxable income, hence making you exempt from paying taxes. You won’t have to pay taxes on the original principal you contributed nor any taxes on capital gains & earnings you have accumulated. Pretty sweet you think for Roth IRAs, eh? In order for the distribution to be classified as ‘qualified’, it must be taken under 1 of the following circumstances:

the Roth IRA investor must be 59 and 1/2 years or older at the time of the distribution
the Roth IRA investor becomes disabled at the time of taking the distributions
the Roth IRA investor dies and his/her beneficiary receives the assets contained in the plan
the distributions taken from the Roth IRA will be used in the purchase or building of a new home for the Roth IRA holder or qualified family member.This is limited to $10,000 per person per lifetime. Qualified family members include:
–> the Roth IRA investor
–> the Roth IRA investor’s spouse
–> children of the Roth IRA investor
–> grandchildren of the Roth IRA investor
–> parent or ancestor of the Roth IRA investor

Note: Even if one of the above prerequisites is met, the Roth IRA must be atleast 5 years old before any distributions can be taken. This is a very important point to consider. For example if you set up your Roth IRA in March 22nd, 2003, you cannot take any distributions, even if they are qualified, until March 22nd, 2010. If you do, this distribution will not be qualified and you will have to pay the 10% early withdrawal penalty as well as income taxes. A few examples to illustrate these concepts would be useful. Here they are.

Example #1

Jim makes Roth IRA contribution on March 1st, 2002 for $3000. 6 years later on March 1st, 2010, Jim withdraws $5500 from his account (the principal $3000 + $2500 earnings). Jim’s withdrawal is not qualified because he does not plan to purchase a home for the first time, nor is he disabled, plus Jim is not 59 and 1/2 years old or more. Jim will face a 10% early withdrawal penalty + have to pay income taxes on his withdrawal. If Jim had withdrawn only $3000 from his Roth IRA which equals the total contributions he made, he would not be subject to income taxes nor the 10% early withdrawal penalty. This is because Roth IRAs allow you to withdraw up to the maximum contributions you have made and not any earnings on those contributions. Since withdrew the whole $5500 consisting of $3000 principal + $2500 earnings, he will be penalized.

Example #2

Rishi who is 58 years old makes a $3500 contribution to his Roth IRA on April 12th, 1999 for the tax year 1998. On February 5th, 2003, Rishi withdraws $6000 from his Roth IRA consisting of $3500 original principal + $2500 earnings. At this time, Rishi is 62 years old. Will this distribution be treated as ‘qualified’? You bet it is! This is because the 5 year waiting rule has passed. Even though Rishi made his contribution on April 12th, 1999, this contribution was designated for the tax year 1998. Thus from 1998 – February 5th, 2003, the 5 year waiting rule is met. As you can see from here, it is not necessarily the calender years that count; it is when the first contribution was made and for what year it was designated. Also, Rishi is 62 years old which meets the 59 and 1/2 year old requirement. Thus this distribution of $6000 will not be included in Rishi’s taxable income.