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Investing Fundamental #6 – Roth IRA (archieve)

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April 18th is the last day to file the 2010 tax return and you can still contribute to the 2010 Roth IRA if you haven’t already done so. If you have any extra money or got early tax refund, this would be a great time to put some away in the Roth IRA for retirement.

Roth IRA is an Individual Retirement Account.  This account in tandem with the 401k is the easiest way to grow a workingman’s  retirement portfolio.

Contributions to Roth IRA are made with after-tax dollars so there are no pre-tax benefits like the 401k.  The benefit of Roth IRA is that it grows tax free.  Once you reach 59 1/2, you will not have to pay any tax when you draw money from this account (aka. take distribution.) More on distribution at the end of the post.

Most people qualify to contribute to Roth IRA and here are the rules:

  • Earned Income – The contribution to Roth IRA must be from earned income. This mean if you didn’t “earn money” this year, then you can’t contribute to the Roth IRA.  Earned income is money earned from working for someone or yourself and it includes salary, wages, tips, and other active income.  You can not use unearned income to contribute to the Roth IRA.  Unearned income usually comes from investments such as interest, dividend, rental income, gifts, and capital gains.
  • Income Limits – If your AGI (adjusted gross income) is too high, the IRS will limit your Roth IRA contribution.  In 2011, if your AGI is more than $179,000 (joint) then you can not contribute to Roth IRA.  There is a linear phaseout area between 169k to 179k.  The phaseout region for Single and Head of Household is from $107,000 to $122,000.   Check the IRS website if you make more than six figures.
  • Contribution Limits – You can contribute $5,000 per calendar year if you’re younger than 50 and $6,000 if you’re older.

Personally, I like Roth IRA quite a bit. It is easy to open a Roth IRA account at a discount brokerage.  You can buy any stock, mutual fund, or bonds that you like.  There are no restrictions like in your 401k account.

retirebyforty’s Roth IRA strategy

> MAX out your 401k contribution first before contributing to Roth IRA.

> Open a Roth IRA account at a discount brokerage to avoid high fees.

> Contribute the max to Roth IRA.  I contribute $5,000 once a year, but you can also set up a monthly auto-transfer for $5,000/12 to take advantage of dollar cost averaging.

> Since the Roth IRA grows tax free, I would put the more high risk high reward investments in this account.  This is a good spot for small cap funds and high growth individual stocks especially if your investment time line is long.

> Don’t withdraw until after 59.5 years old to maximize compound investing, avoid tax and possible 10% penalty. *see below*

> If your child earned over $5,000 this year, it could be a good idea to gift $5,000 toward his/her Roth IRA if you can afford it.  The earlier you start investing, the better off you’ll be in the future.

Are you contributing to a Roth IRA?  Don’t miss out on this great investment opportunity.

Roth IRA Distribution

You can withdraw your contribution(money you invested) at anytime with no penalty. I don’t recommend this though because we want to let the investment compound. You can also take early distribution on the gain if you need, but you may have to pay a tax and possibly penalty. Here is a nice flow chart from the IRS. You can see this IRS page for all the gritty details.

irs roth ira early distribution flow chart

Exceptions. You may not have to pay the 10% additional tax in the following situations.

  • The distributions are part of a series of substantially equal payments.
  • You have significant unreimbursed medical expenses (over 7.5% of your AGI.)
  • You are paying medical insurance premiums after losing your job.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.
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