ROTH IRA Investing & Distribution

Posted  65 Views updated 20 days ago
ROTH IRA Investing & Distribution



Many types of retirement accounts become obsolete if the owner of the account engages in non-qualified early distributions. One exception to this rule is for Roth IRA accounts. These are designed after traditional IRA accounts; however, they do not receive special tax treatment during establishment while contributions are made, but instead does so when it comes time to withdraw funds while following the rules of the Internal Revenue Code. The advantage to this is that contributions made can be withdrawn without penalty or tax consequence at any time even before retirement age for use as a down payment on a home, going back to school, etc. Withdrawals during retirement are not taxable if certain requirements have been met.


The Internal Revenue Service has rules that establish how Roth IRA accounts should be treated if applied to certain situations such as death of the account owner, divorce and more. One requirement of these rules is that only one Roth IRA account exists for each individual by "designated Roth accounts."


The Internal Revenue Service defines a designated Roth account as: “a collection of plan contributions that are separately accounted for under the plan and designated by the plan as Roth contributions.”


This means that one person can have only one of these accounts in an employer sponsored retirement account. If anyone else has a Roth IRA, it must be treated as another person's designated Roth account, making it no longer applicable to the original owner.


A Roth IRA account can be made for an individual even before they are eligible to participate in the employer's tax-advantaged retirement plan. However, this is not exactly "designated" since it does not meet IRS regulations for total yearly contributions that may be applied towards the designated Roth account. If you find yourself ineligible to contribute directly into a Roth IRA, you may still be able to contribute into a traditional IRA account and then convert it directly or through another broker to a Roth IRA account.


Since the same individual cannot have more than one Roth IRA in their name, what happens when there is an ex-spouse? Does the reason for divorce invalidate the Roth IRA since it no longer applies to a single individual? The answer is no. Any contributions made into the Roth IRA exist as a separate entity from family members and can be kept that way during divorce proceedings under IRS rules.


The same holds true for changes of name by marriage, death or other events. If you move from Smith to Johnson, your Roth IRA does not move with you. For this reason, it is important that you keep all forms regarding your Roth IRA intact and easily accessible in the event of an emergency to prove you are still eligible for your contribution limits.


If you have multiple employers, each one may offer a different retirement plan option. This means that only one can be designated as your Roth IRA. One of these may be an employer sponsored 401k plan, but that doesn't automatically mean it will be treated as your designated Roth account if you are still working elsewhere with other qualified plans available to you. The designated Roth account must meet certain requirements for qualification, such as ownership and employer eligibility under the rules of the Internal Revenue Service.


For more information on the rules of designated Roth accounts, visit the IRS website at www.irs.gov or consult a qualified tax professional.


What Happens to a Designated Roth IRA Account at the Death of its Owner?


The designated Roth IRA will pass to your beneficiary(ies) just like a traditional IRA, except it won't affect your income tax. If you have multiple Roth IRAs and leave them for different beneficiaries, each one can be treated as if it is a separate account. These accounts do not need to be combined and will pass to each designated beneficiary as separate accounts.


Forms 1099-R for Roth IRA distributions must be issued in the year of death, even if the distribution is after the account owner's death. If a spouse inherits a Roth IRA and names his or her own beneficiary, he or she must close the old account and create a new one to name the beneficiary. 


If a Roth IRA account owner dies prior to meeting the required five-year holding period for qualified distributions, any earnings on the designated Roth account that were distributed as a non-qualified distribution will be taxed as ordinary income and may be subject to an additional 10 percent early withdrawal penalty if made within the first five years of the account opening.


Pre-Tax Deferrals vs After-Tax Contributions


The designated Roth IRA allows for after-tax contributions, but what happens if you already made pre-tax deferrals into a traditional IRA and then convert it to a Roth conversion? Do you get taxed twice: once when you make the catch-up contribution into the traditional IRA and again when you withdraw from the conversion during retirement? The answer is no. Under IRS regs, you can return the pre-tax deferral to your designated Roth IRA account when you make the conversion and there will be no double taxation.


This does not apply when making a withdrawal from a traditional IRA, since it was originally made with pre-tax dollars and taxed upon distribution. However, under IRS  rules, you must remove the after-tax contributions first until all amounts returned to the traditional IRA are of pre-tax type. This means that if you only had Roth dollars in your traditional IRA and no pre-tax earnings or deductible contributions, then a withdrawal would be 100 percent tax and penalty free.


Taxes on Designated Roth IRA Account


There are no taxes due on the earnings of a Roth IRA as long as it meets certain qualifications. Withdrawals from designated Roth IRAs that meet the five-year holding period and are over age 59 1/2 will be tax free because the account was funded with after-tax dollars. If you exceed this limit, your withdrawal may be subject to income taxes and a possible 10 percent early withdrawal penalty. 


Maximum Contribution In Roth IRA ?


The maximum annual contribution in a Roth IRA is currently $5,000. There is also an additional catch-up contribution allowed to those age 50 and older of $1,000. For example, if you are 35 years old and expect to contribute the maximum amount each year until retirement (age 59 1/2), you could put away a maximum of $140,000.


If you still have money left to contribute at age 50, the additional catch-up contribution of $1,000 per year gets you another $10,000 - making a total of $150,000 over 20 years. In addition to the Roth IRA maximum contributions each year there is an additional limit on total contributions.


The maximum total combined contribution to all your traditional and Roth IRA accounts is the smaller of 100 percent of your earned income or $5,000 ($6,000 if you are age 50 or older). 


Earned Income Defined For Maximum Contribution

 

Taxable compensation includes wages, salaries, commissions and self-employment income from a business or profession. Related but excluded types of income include net earnings from self-employment, alimony and separate maintenance payments, nontaxable combat pay, taxable scholarship and fellowship grants as reported on the recipient's Form W-2.


Taxable compensation also includes earned income that is not subject to income tax withholding, such as interest and dividends. Earned income does not include capital gains, IRA distributions or Social Security benefits; however, it may include amounts that are subject to the 15-percent additional tax on early distributions of savings incentive match plans for employees (SIMPLE).


Maximum Contribution For Roth IRA Withdrawal At 59 1/2

 

Recently, a reader asked if all of the money in his traditional IRA had to be withdrawn after age 59 1/2. The answer is no, he can leave it in place and continue adding to it each year until retirement when it will then be subject to mandatory withdrawal beginning at age 70.

If he did not need the money before retirement, he could even convert some or all of his traditional IRA to a Roth IRA and thereby avoid any immediate tax liability. The situation is different with Roth IRAs because there is no age limit on withdrawals; however, your distributions must meet certain qualifications to be free of income taxes and penalties.

IRS Publication 590-B contains the rules governing qualified distributions. These are designed to prevent abuse of Roth IRAs, which is similar to what ultimately happened with traditional IRAs.


Roth IRA Withdrawals - Allowable Distributions

 

The five permissible distribution methods for Roth IRA accounts are generally based on the age and life expectancy of the account owner and his or her beneficiary. The distribution rules also apply to the designated Roth IRA accounts.

The five permissible methods are: 

1) The 5-year method, which is perfect for those who expect their tax rate to drop in retirement; 

2) The life expectancy method, which is perfect for those who will not need their Roth IRA money during retirement; 

3) The annuity method, which is perfect for those who will need to use the money (and want an upfront tax deduction); 

4) The modified endowment method, which is perfect for those seeking tax-free withdrawals of investment earnings; and 

5) The required minimum distribution method, which is perfect for those who must withdraw a certain amount each year because of unacceptable financial hardship.

To be clear, these are the five methods that can be used to calculate qualified distributions from Roth IRA accounts. There are additional rules governing Roth IRA conversions and rollovers to Roth IRAs from other retirement plans or IRAs.

Roth IRA Contributions Can Be Moved To Another Roth IRA Account - But Only Once

 

A reader asked if she could move the contributions she had made to a Roth IRA account under her employer's 401(k) plan to a new separate Roth IRA account after leaving that job. The short answer is no, but there are ways around this seemingly straight-forward answer.


To accomplish this, you must make a trustee-to-trustee transfer from the Roth IRA account where the contributions were made directly to the new Roth IRA account. This is an important requirement because it means that no money can be moved from one personal bank or investment account to another for this purpose. The only exception is when you rollover your Roth IRA into a new account, but you still must meet the other requirements.


Roth IRA Withdrawals - Penalties and Taxes

 

Early withdrawal of contributions from a traditional IRA is subject to tax and may be penalized unless an exception applies. The situation is different with Roth IRAs because there is no early withdrawal penalty for those who meet the five requirements, which include:

1) You must be 59 1/2 years old; 

2) The Roth IRA account must have been opened for at least five tax years; 

3) Your distribution must be a qualified distribution (i.e., it is not subject to the 10% early withdrawal penalty); and

4) You have not made any non-qualified distributions from the Roth IRA account. 

In addition, your withdrawal must be a qualified distribution or you may owe income tax on the amount withdrawn as well as a 10% early withdrawal penalty if you are under age 59 1/2. This is why it is critical that your distribution is qualified.


Additional Resources

IRS publication 590: Individual Retirement Arrangements (IRAs) provides more information on IRA rules and regulations. Its website at www.irs.gov is also helpful when searching for more specific questions about the designated Roth account. It is important to remember that all forms and publications apply to traditional IRAs as well, so be sure you know which IRA you have.



0 Comments