How Does the Roth IRA Work?

Time is a factor in how a Roth IRA works.

Time is a factor in how a Roth IRA works.

One of the primary differences between a traditional IRA and a Roth IRA is that you cannot deduct contributions to a Roth. This might seem like a downer, but the upside is at the distribution end. When you take money out of a Roth after reaching retirement age, you pay no taxes at all. The traditional IRA holder must fork over income tax no matter when the funds are withdrawn.

Yearly Contribution Limit

The Internal Revenue Service sets limits on how much you can put into any IRA in a calendar year. As of 2012, the limit is $5,000 for people under age 50 and $6,000 for those 50 and older. When it comes to the limits, the IRS sees all IRAs as one IRA. you can contribute only $5,000 in total, no matter how many iRAs you hold. So if you have two Roths and one traditional IRA, for example, you can put $1,000 in each of the Roths and $3,000 in the traditional account. You cannot contribute $5,000 to each.

Withdrawal Rules

You can take the money you put into a Roth out of the account at any time for any reason. This is another factor that distinguishes the Roth from the traditional IRA. However, you cannot take out earnings tax-free and penalty-free unless you have owned a Roth for at least five years and you have reached age 59 1/2. If you meet neither test, you'll owe both ordinary income tax and a 10 percent penalty on the earnings amount. If the account is 5 years old and you are not yet 59 1/2, you'll pay just a 10 percent penalty on an earnings distribution.

Rollover Restrictions

You can roll over, or convert, a Roth IRA only to another Roth IRA. One reason is that most other retirement account types are made up of pretax contributions. The Roth includes only after-tax money. You can, however, roll a pretax account, such as a 401(k) or defined benefit plan, into a Roth. You must pay income tax on a rollover from a pretax-contribution account to a Roth when you file your return. You can only convert to or from a Roth once in a 12-month period.

Rollover Withdrawals

If you roll money into a Roth from a pretax account, such as a traditional IRA or a 401(k), you must wait five years to withdraw the funds. If you take the money out sooner, you'll owe a 10 percent penalty on the withdrawal.

No Age Restrictions

You can open a Roth IRA at any age, as long as you have what the IRS defines as earned income. This includes wages, commissions, salaries and tips, as well as alimony. You cannot put investment or pension income into any IRA.

You never have to take any distributions if you don't want to. You can leave the account intact for transfer to your heirs whose required withdrawals -- as long as the account has been open for five years -- will also be tax-free.

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