||Ask the Dollar Diva
Is the Roth IRA too good to
Dear Dollar Diva,
In your column What's
the difference between a 401(k) plan and an IRA? you state that
"If you hold the funds in a Roth IRA for at least five years and
make your withdrawals after you reach age 59-1/2, none of your withdrawals
will be taxable. You heard that right. Neither your contributions
nor the interest/dividends/capital gains earned are taxable. Ever.
Even if you die. Your beneficiary doesn't have to pay taxes on it."
I have a booklet stating that monies are distributed
from a Roth IRA as follows:
- Original after-tax contributions -- non taxable
- Remaining earnings -- taxable
I'm not trying to be a smart-ass, but what you say
about the Roth IRA seems too good to be true. How can all interest
and dividends accumulated in a Roth IRA not be taxable? Any source
of reading would be appreciated.
There are two types of distributions from a Roth IRA:
those that are qualified, and those that are not. The Diva's quote
refers to qualified distributions, it looks like your booklet refers
to those that are not.
According to current law, there is no income tax on
any part of qualified distributions from a Roth IRA. You heard that
right: none. Accumulated interest, dividends and capital gains go
to you tax-free in a qualified distribution. It's very sweet indeed.
To be qualified, the distribution has to be made at
least five years after the first contribution to your Roth IRA was
made. Once that period has passed, a distribution is qualified if
any of the following are true:
- You have reached age 59-1/2
- You are disabled
- You die and the distribution is made to a
beneficiary or your estate
- It's for qualified first-time home buyer expenses,
up to a lifetime maximum of $10,000
If your distribution is made before the five year
period is up, or it doesn't fall into any of the qualifying categories,
then it's a non-qualifying distribution, and part of it may be taxed.
The IRS has a set order in which it considers contributions and
earnings to be withdrawn from a Roth IRA.
| Regular contributions
| Conversions from traditional
IRA to Roth IRA
|| Taxable portion first, if
applicable; then non-taxable portion
| Earnings: dividends, interest,
For more information on Roth IRA qualifying and non-qualifying
distributions read IRS
Publication 590, Individual Retirement Arrangements (IRAs) (Including
Roth IRAs and Education IRAs).
What's so good about the Roth IRA?
The Diva likes the Roth IRA. It has some lovely features:
- Qualified distributions are tax-free
- Contributions can be made as long as you
work, even if you're 100 years old
- Distributions don't have to start at age
70-1/2, or ever. That baby can fatten up on non-taxable, compound
earnings into eternity
But in spite of these pluses, if you're marginal tax
rate is 28 percent or more, she recommends that you fund the following
before you ante up for a Roth:
- 401(k) plans, at least up to the amount the
- All other tax-deferred options, such as traditional
IRA, SEP, Keogh
If you're in the 15 percent tax bracket, and expect
to be in a higher tax bracket in the future, the Roth makes more
What's not so good about the Roth IRA?
The Diva likes the Roth IRA, but it's not perfect.
Here are some of the negative things you need to think about:
- Roth contributions are not tax-deductible.
A taxpayer in the 28 percent tax bracket is only out-of-pocket
$1,440 when he makes a $2,000 contribution to a tax-deferred plan
because of the tax savings. That's $560 more he has to invest
elsewhere. In other words, he only has to spend $2,000 to have
$2,560 working for him.
- Watch out for the hidden costs of converting
from a traditional IRA to a Roth IRA
- It can push you into a higher tax bracket
- If you're collecting Social Security,
more of it probably will be taxed
- The addition to adjusted growth income
may cause you to lose benefits such as education and child
tax credits or deductions for student loans.
- Current federal law protects qualified Roth
IRA distributions from tax. Will future law do the same? Up to
85 percent of Social Security can be subject to tax. Will that
be the fate of the Roth IRA 30 years from now?
- Most states have not updated their laws to
protect Roth IRAs from lawsuits and creditors in the same way
that traditional IRAs are protected.
-- Posted: July 27, 2000