In 1997, the federal government passed the Taxpayer Relief Act, which introduced the Roth individual retirement account as a alternative IRA for taxpayers with lower incomes. The Roth IRA offers after-tax savings, which is most beneficial for people who expect to fall in a higher tax bracket when they plan to take the withdrawals than they fall in for the year that they make the contribution.
Who Can Contribute
The IRS requires that to contribute to a Roth IRA, you have earned income equal to or greater than your contribution and that your modified adjusted gross income does not exceed the annual limits. These limits change each year for inflation and differ depending on your filing status. You can find the current limits in IRS Publication 590 (see Resources). If your modified adjusted gross income exceeds the limits, you cannot contribute to a Roth IRA.
How Much Can You Put In?
Roth IRAs limit the amount of money that you can put into the account each year. The IRS adjusts the amount for inflation annually. For 2010, the limit equals $5,000. If you are 50 or older, you can contribute $6,000. If you contribute more than your allowed maximum, you will have to pay a 6 percent penalty on the excess every year until you remove the money.
Roth IRA contributions receive no income-tax deductions, unlike traditional IRA contributions. The money in a Roth IRA receives tax-sheltered status, meaning that any earnings on the account are not subject to income taxes. The biggest tax benefit of Roth IRAs is that qualified withdrawals taken out of the account are not counted as taxable income.
When Can I Take Out Money?
You can remove money from your Roth IRA at any time, for any reason. However, non-qualified withdrawals of earnings are subject to income taxes and a 10 percent early withdrawal penalty. To take a qualified withdrawal, you must be at least 59 1/2 years old and your Roth IRA must have been open for at least five tax years. Contributions can be withdrawn tax-free and penalty-free at any time because the contributions are made with after-tax dollars. Conversely, you can leave money in the Roth IRA as long as you want because Roth IRAs are not subject to required minimum distributions.
Early Withdrawal Exceptions
You can avoid the early withdrawal penalty and even the income taxes on earnings taken out of your Roth IRA in several circumstances. The early withdrawal penalty is waived if you use the money because your are permanently disabled, have medical expenses exceeding 7.5 percent of your adjusted gross income, have college costs or need up to $10,000 for your first home purchase. If the early withdrawal is taken for a permanent disability or your first home purchase and the account has been open for at least five years, the income taxes are also waived.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."