Basics of a Roth IRA

Traditional IRAs have long been popular with investors. For many people, they offer a substantial current income tax deduction. And the assets in an IRA grow tax deferred.

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Unfortunately, there are some significant eligibility restrictions for traditional deductible IRAs. If you’re an active participant in a qualified retirement plan — such as a simplified employee pension plan or a 401(k) plan — your IRA deduction could be reduced or eliminated if your income is above certain levels.

Tax-favored Roth IRA status

Unlike traditional deductible IRAs, taxpayers cannot deduct contributions made to Roth IRAs. However, unlike the case with traditional IRAs, qualified distributions from Roth IRAs aren’t included in a taxpayer’s gross income or subject to the additional 10 percent federal income tax penalty for early withdrawals.

This means that qualified withdrawals from a Roth IRA will be free of federal income tax.

Qualifying IRA Distributions

To qualify for a tax-free withdrawal at retirement (after age 59 ½), a distribution must be made after a five-year holding period. In other words, you cannot make a withdrawal until five years from the first tax year you make a contribution to your Roth IRA.

After this initial holding period, you may also make withdrawals due to death or disability, or to purchase your first home (up to a $10,000 lifetime cap), without triggering federal income taxes or being subject to the 10 percent federal income tax penalty for early withdrawals.

You may also withdraw funds from your Roth IRA for college expenses (after the initial five-year holding period) without incurring the 10 percent penalty, although regular income taxes would be due on withdrawn earnings.

Keep in mind that although qualified distributions are free of federal income taxes, state and/or local taxes may apply in some states.

Limits

For tax years 2002 to 2004, the Roth IRA contribution limit is $3,000, and it will gradually reach $5,000 in 2008.

Eligibility to contribute to a Roth IRA phases out for taxpayers with higher incomes. Eligibility begins phasing out for single filers with adjusted gross income of $95,000, phasing out completely when adjusted gross income reaches $110,000. Similarly, eligibility begins phasing out for married taxpayers (filing jointly) with adjusted gross income of $150,000, phasing out completely when adjusted gross income reaches $160,000.

"Catch-Up" Contributions

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Special "catch-up" contribution provisions enable those nearing retirement to save at an accelerated rate. Those aged 50 and older before the end of the taxable year will be eligible to contribute more than the regular limits. Eligible Roth IRA participants may contribute an additional $500 per year from 2002 through 2005, and an additional $1,000 per year thereafter. This is in addition to the otherwise maximum contribution limit (before application of adjusted gross income phase-out limits).

Unlike a traditional IRA, there are no penalties if you make contributions to (or fail to take minimum distributions from) a Roth IRA after you reach age 70½.

If you’re looking for a retirement savings vehicle with some distinct tax advantages, the Roth IRA could be right for you.

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