The Roth IRA is a traditional IRA that has no tax-deductible contributions but provides other benefits. In certain cases, earnings are tax-free and withdrawals are tax and penalty free. The main advantage is that the earnings can accumulate free of tax however only after making a taxable deduction.
There is a limit on annual contributions to these accounts of $3000 for individuals and $4000 for married couples. These amounts are phased out when the adjusted gross income (AGI) hits $95,000 for individuals and $150,000 for couples filing a joint return (although these numbers change from year to year). Single taxpayers with an AGI above $110,000 or couples filing jointly with an AGI over $160,000 are not eligible to open Roth IRAs (although these numbers also change from year to year). Contributions made after the limit are subject to a 6% penalty.
There are no restrictions on withdrawals of contributions at anytime, however, earnings on those contributions can only be taken tax-free and without penalty under the following circumstances:
- Five-year holding period of the account
- Reach age of 59 1/2
- Take up to $10,000 for the purchase of a first home
Conversion amounts have to meet the five-year holding period rule prior to having the ability to make tax-free and penalty-free withdrawals. If these conditions are not met, there is a 10% penalty and the withdrawals made on these conversion amounts or any accumulated earnings are subject to regular income taxes.
Distributions are tax-free for all regular contributions, also for any rollover or conversion contributions.
Recharacterization is the term used to describe a change in the type of account. It works for regular, non-rollover contributions and for Roth IRA conversion or rollover contributions.Since it is a change in the type of account, note that it is not the only way to deal with contributions that were not meant to be in a certain account; rollovers and withdrawals can also work.Some of the uses for recharacterizations are listed here.
- Failed conversion
If you converted a traditional IRA into a Roth IRA, have a modified AGI of more than $100,000, or have experienced a change in your marital status, you can setup a regular IRA instead of the Roth as if the original conversion had not happened. This has to be done in the same year the contribution was made.
- Successful but unwanted conversion
If the conversion was the result of a mistake given your financial situation, you can also setup a regular IRA instead of the Roth as if the first conversion had not happened.
- Market losses after conversion
In certain cases, you can undo a conversion if the account suffered some losses due to the market that reflect on higher taxes. There are some regulations that restrict your ability to use this rule in this particular case, however it might come in handy.
- Annual contribution to a traditional IRA
If you made an annual contribution to a traditional IRA and you change your mind and want to make the contribution to a Roth IRA, you can make a traditional IRA the recipient of the contribution using this rule.
- Annual contribution to a Roth IRA
Similar to the one above, but using a Roth IRA instead.
In all cases, the recharacterization has to be done by the due date of the tax return of the year when the contribution was made. Once a recharacterization is done, there is no turning back, it is said to be an irrevocable election. In general, you can only switch your contribution if you also switch the earnings on that contribution.
- Failed conversion