Roth IRA

A Roth IRA is an Individual Retirement Account (IRA) allowed under the tax law of the United States. Named for its chief legislative sponsor, the late Senator William Roth of Delaware, a Roth IRA differs in several significant ways from other IRAs.

Roth IRA Overview:
Established by the Taxpayer Relief Act of 1997 (Public Law 105-34), a Roth IRA (Individual Retirement Account) can invest in securities, common stocks or mutual funds. Other investments are also possible, and these include certificates of deposit, real estate, notes and derivatives. The Internal Revenue Service mandates specific eligibility and filing status requirements for a Roth IRA, as they do for all other forms of individual retirement accounts.  The tax structure of a Roth IRA is its main advantage, and depending on how and with whom it is set up it can house investments in non-typical assets. This is true if the Roth IRA is set up as a self directed IRA.

For a table of current Roth IRA contribution limits, refer to Wikipedia.

Self Directed Roth IRA

Roth IRAs are available from self-directed IRA companies just like traditional IRAs.  The benefit of a self-directed Roth IRA is that you choose which investments that will help you save for retirement, and there are very few types of investments that you are not allowed to hold in a self-directed Roth IRA.  In addition to the standard investments of stocks, bonds, cash, money market funds, and mutual funds, you can also hold other investments that are not typically offered by traditional retirement investment companies. For example, in a self-directed Roth IRA, you can purchase investment real estate, promissory notes, shares in a private placement, and even participate in peer-to-peer lending.  You can also hold other investments such as partnerships, franchises, tax liens, and crowdfunded real estate investments.

Differences between a Roth IRA and Traditional IRA

Contributions to a traditional IRA are tax deferred, but contributions to a Roth IRA are not.  One advantage of a Roth IRA is that there are less restrictions and requirements for withdrawal.  The transactions in a Roth IRA do not include a tax liability for capital gains, dividends or interest.  Withdrawals are usually tax free, but not always and stipulations will apply.  For example, a withdrawal will be tax free for the growth portion of the asset above principle if the account has been open for minimum of five years for principle withdrawals and the owners age is at least 59½  years old.


  • Direct contributions to a Roth IRA may be withdrawn tax free at any time.  Rollover, converted (before age 59½) contributions held in a Roth IRA may be withdrawn tax and penalty free after the “seasoning” period currently set at 5 years.  Earnings may be withdrawn tax and penalty free after the seasoning period if the condition of age 59½ (or other qualifying condition) is also met.  This differs from a traditional IRA where all withdrawals are taxed as Ordinary Income, and penalties apply for withdrawals before owner is age 59½.  In contrast, capital gains on stocks or other securities held in a regular taxable account for at least a year would be taxed at the lower long-term capital gain rate, which is currently 15%.  This potentially higher tax rate for withdrawals of capital gains from a traditional IRA is an equalizer for the deduction taken against ordinary income when putting money into the IRA initially.
  • If there is money in the Roth IRA due to conversion from a traditional IRA, the Roth IRA owner may withdraw up to the total of the converted amount without penalty, as long as the current seasoning period of five years has passed on the converted funds.
  • Up to $10,000 in earnings withdrawals are considered qualified (tax-free) if the money is used to acquire a principal residence for a first time buyer.  This house must be acquired by the Roth IRA owner, their spouse, or their lineal ancestors and descendants.  The owner or qualified relative who receives such a distribution must not have owned a home in the previous 24 months.
  • Contributions may be made to a Roth IRA even if the owner participates in a qualified retirement plan such as a 401k.  In this scenario, contributions can still be made to a traditional IRA but they may not be tax deductible.
  • If a Roth IRA owner dies, and his/her spouse becomes the sole beneficiary of that Roth IRA while also owning a separate Roth IRA, the spouse is permitted to combine the two Roth IRAs into a single account without penalty.
  • If the Roth IRA owner expects that the tax rate applicable to withdrawals from a traditional IRA in retirement will be higher than the tax rate applicable to the funds earned to make the Roth IRA contributions before retirement, then there may be a tax advantage to making contributions to a Roth IRA over a traditional IRA or similar vehicle while working.  There is no current tax deduction, but money going into the Roth IRA is taxed at the taxpayer’s current marginal tax rate, and will not be taxed at the expected higher future effective tax rate when it comes out of the Roth IRA.  Taxes are applied up front at today’s tax rate.
  • Assets in the Roth IRA can be passed on to heirs, unlike Social Security benefits.
  • The Roth IRA does not require distributions based on age.  All other tax-deferred retirement plans, including the related Roth 401k, require withdrawals to begin by April 1 of the calendar year after the owner reaches age 70½.  If you don’t need the money and want to leave it to your heirs, this is a great way to accumulate income tax free.  Beneficiaries who inherited Roth IRAs are subject to the minimum distribution rules.
  • Since a Roth contribution has already been taxed, it may be equivalent to a larger contribution to a traditional IRA that will be taxed upon withdrawal.  However, many people end up in a lower tax bracket in retirement, or, the effective tax rate applicable to their traditional IRA withdrawals in retirement will be equal to or lower than their marginal tax rate while working, and they will not realize as much of this benefit. Regardless of whether marginal tax rates increase or decrease, Roth IRA earnings are not taxed if you follow the rules.
  • While a traditional IRA is valued at the pre-tax level for the purpose of estate taxes, the tax dollars have already been subtracted from the Roth IRA, thus reducing estate tax liability.


  • Contributions to a traditional IRA are, within income limits, tax deductible while contributions to a Roth IRA are not.  Therefore, someone who contributes to a traditional IRA instead of a Roth IRA gets an immediate tax savings equal to the amount of the contribution multiplied by their marginal tax rate. Someone who contributes to a Roth IRA does not realize this immediate tax reduction.  Also, by contrast, contributions to most employer sponsored retirement plans (such as a 401k, 403(b), SIMPLE IRA or SEP IRA) are tax deductible with no income limits because they reduce a taxpayer’s adjusted gross income.
  • Eligibility to contribute to a Roth IRA phases out at certain income limits.  Most other tax deductible employer sponsored retirement plans do not have an income limit.
  • Contributions to a Roth IRA do not reduce a taxpayer’s adjusted gross income (AGI).  By contrast, contributions to a traditional IRA or most employer sponsored retirement plans reduce a taxpayer’s AGI.  One of the key benefits of reducing one’s AGI (aside from the obvious benefit of reducing taxable income) is that a taxpayer who is close to the threshold income of qualifying for some tax credits or tax deductions may be able to reduce their AGI below the threshold at which he or she may become eligible to claim certain tax credits or tax deductions that may otherwise be phased out at the higher AGI had the taxpayer instead contributed to a Roth IRA.  Likewise, the amount of those tax credits or tax deductions may be increased as the taxpayer slides down the phase-out scale.  This would include earned income credit, a student loan interest deduction and the child tax credit.
  • A taxpayer who chooses to make a contribution to a Roth IRA (instead of a traditional IRA contribution or tax deductible retirement account contribution) while in a moderate or high tax bracket will likely pay more income taxes on the earnings used to make the Roth IRA contribution as compared to the income taxes that would have been due to be paid on the funds that would have been later withdrawn from the traditional IRA, had the taxpayer made a traditional IRA contribution.  This is because contributions to traditional IRAs or employer sponsored tax deductible retirement plans result in an immediate tax savings equal to the taxpayer’s current marginal tax bracket multiplied by the amount of the contribution.  Studies show that many people have a lower income in retirement than during their working years, and thus end up in a lower tax bracket in retirement.  This is another reason why withdrawals from a traditional IRA or tax deferred retirement plan in retirement are likely to result in a lower tax bill.  The higher the taxpayer’s marginal tax rate, the greater the disadvantage.
  • A taxpayer who pays state income taxes and who contributes to a Roth IRA (instead of a traditional IRA or a tax deductible employer sponsored retirement plan) will have to pay state income taxes on the amount contributed to the Roth IRA in the year the money is earned. However, if the taxpayer retires to a state with a lower income tax rate, or no income taxes, then the taxpayer will have given up the opportunity to avoid paying state income taxes altogether on the amount of the Roth IRA contribution by instead contributing to a traditional IRA or a tax deductible employer sponsored retirement plan, because when the contributions are withdrawn from the traditional IRA or tax deductible plan in retirement, the taxpayer will then be a resident of the low or no income tax state, and will have avoided paying the state income tax altogether as a result of moving to a different state before the income tax became due.
  • The perceived tax benefit may never be realized, i.e., one might not live to retirement or much beyond, in which case, the tax structure of a Roth only serves to reduce an estate that may not have been subject to tax. Living until one’s Roth IRA contributions have been withdrawn and exhausted is the only way to fully realize the tax benefit.  In contrast, with a traditional IRA tax might never be collected at all; If the owner dies prior to retirement with an estate below the tax threshold, or goes into retirement with income below the tax threshold (to benefit from this exemption, the beneficiary must be named in the appropriate IRA beneficiary form.  A beneficiary inheriting the IRA solely through a will is not eligible for the estate tax exemption.  Additionally, the beneficiary will be subject to income tax unless the inheritance is a Roth IRA.  Heirs will have to pay taxes on withdrawals from traditional IRA accounts they inherit and must continue to take mandatory distributions based on life expectancy.  It is also possible that tax laws may change by the time one reaches retirement age.
  • Congress may change the rules that currently allow for tax free withdrawal of Roth IRA contributions.  Therefore, someone who contributes to a traditional IRA is guaranteed to realize an immediate tax benefit, whereas someone who contributes to a Roth IRA must wait for a number of years before realizing the tax benefit, and that person assumes the risk that the rules might be changed during the interim. On the other hand, taxing earnings on an account which were promised to be untaxed may be seen as a violation of contract – individuals contributing to a Roth account now may in fact be saving themselves from new, possibly higher income tax obligations in the future.

Double taxation

Foreign dividends may be taxed at their point of origination, and the IRS does not recognize this tax as a creditable deduction.  So, double taxation can still occur on tax sheltered investment accounts.

For Canadians with US Roth IRAs:  A rule established in 2008 provides that Roth IRAs (as defined in section 408A of the U.S. Internal Revenue Code) and similar plans are considered to be pensions.  Accordingly, distributions from a Roth IRA and other similar plans to a resident of Canada will generally be exempt from Canadian tax to the extent that they would have been exempt from U.S. tax if paid to a resident of the U.S. Additionally, a resident of Canada may elect to defer any taxation in Canada with respect to income accrued in a Roth IRA but not distributed by the Roth IRA, until and to the extent that a distribution is made from the Roth IRA or similar plan. In most cases, no portion of the Roth IRA will be subject to taxation in Canada.

However, where an individual makes a contribution to a Roth IRA while they are a resident of Canada, with the exception of a rollover contribution from another Roth IRA, the Roth IRA will lose its status as a “pension” for purposes of the Treaty with respect to the accretions from the time such contribution is made.  Income accretions from such time will be subject to tax in Canada in the year of accrual.  In effect, the Roth IRA will be bifurcated into a “frozen” pension that will continue to enjoy the benefit of the exemption for pensions and a non-pension (essentially a savings account) that will not.

Eligibility for a Roth IRA

Income limits

Congress has limited who can contribute to a Roth IRA based upon income.  A taxpayer can only contribute the maximum amount listed at the top of the page if their Modified Adjusted Gross Income (MAGI) is below a certain level (the bottom of the range shown below).  Otherwise, a phase-out of allowed contributions runs proportionally throughout the MAGI ranges shown below.  Once MAGI hits the top of the range, no contribution is allowed at all, however a minimum of $200 may be contributed as long as MAGI is below the top of the range (e.g. A single 40 year old with MAGI $119,999 may still contribute $200 to a Roth IRA vs. $30).  Excess Roth IRA contributions may be recharacterized into Traditional IRA contributions as long as the combined contributions do not exceed that tax year’s limit.

Once a Roth IRA is established, however, the balance in the account remains tax-sheltered even if the taxpayer’s income rises above the threshold.  The thresholds are for annual eligibility to contribute, and not for eligibility to maintain the Roth IRA.

To be eligible, you must meet the earned income minimum requirement.  In order to make a contribution, you must have taxable compensation (not taxable income from investments).  If you make only $2,000 in taxable compensation, your maximum IRA contribution is $2,000.

Conversion limit

Through 2009 only taxpayers with MAGI of less than $100,000 in the year of conversion and not married filing separately were allowed to convert from a traditional IRA to a Roth IRA (the converted amount is not included in MAGI).  TIPRA 2005 eliminated the MAGI limit and filing status restriction on conversions starting in 2010.  Regardless of income, contributions can have been made to a traditional IRA in previous years, and then rolled over in 2010 and beyond.


Direct contributions may be withdrawn at any time.  Eligible tax and penalty-free distributions of earnings must fulfill two requirements:  First, the seasoning period of five years must have elapsed, and secondly a justification must exist such as retirement or disability.  The simplest justification is reaching 59.5 years of age, at which point qualified withdrawals may be made in any amount on any schedule.  Becoming disabled or being a “first time” home buyer can provide justification for limited qualified withdrawals.  Finally, although one can take distributions from a Roth IRA under the substantially equal periodic payments (SEPP) rule without paying a 10% penalty, any interest earned in the IRA will subject to tax and will be a substantial penalty.

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