9.8.2 The Roth IRA
The Roth IRA is similar to the traditional IRA, yet when it comes to taxation it seems backward. With the traditional, contributions are nontaxable as income until the funds are withdrawn; then they become taxable. With the Roth, just the opposite is true. The funds are taxed as income before the contribution is made. In other words, Roth contributions are made with after-tax dollars. Therefore, at the time of payout, the funds are tax free.
The annual contribution limit to a Roth IRA for any eligible individual is $5,000 (2012, same as 2011). Additional catch-up contributions (2011 and thereafter) is $1,000.
And, again unlike the traditional IRA, the Roth imposes no age limits. Roth withdrawals are either qualified or nonqualified.
Also, unlike traditional IRAs, Roth IRA distributions are not mandatory and can therefore be inherited and passed down through generations.
Qualified Withdrawal
A qualified withdrawal provides the tax-free distribution of earnings. To be a qualified withdrawal, the funds must have been held in the account for a minimum of five years; and if the withdrawal occurs for one of the following reasons, no portion of the withdrawal is subject to tax.
- The owner has reached age 59 1/2
- The owner dies or becomes disabled
- The distribution is used to purchase a first home
Nonqualified Withdrawal
If a withdrawal is taken without meeting the above criteria and the amount of the withdrawal exceeds the total amount contributed, it is a nonqualified withdrawal. The earnings from the contributions become taxable.
Illustration 13.4 in the study manual demonstrates tax consequences of IRA distributions.
