It would be great to tell you that eligibility rules for a Roth IRA are easy, and you simply can or can’t open an IRA. But the IRS is involved here since it is tax law that governs Roths. And that always means the rules are complicated and have a lot of exceptions.
One rule may allow you to open a Roth, but another rule states that you can’t contribute any money this year. Sometimes one rule says you can contribute, but another rule says your contribution is $0. It can drive you nuts. So, we’ll simplify the rules for the average person.
Roth IRA Eligibility Considerations
You’ll want to look at 6 general aspects of yourself to see if you can open a Roth account.
- Earned Income
- Age
- Contribution Limit
- Income Limits
- Contribution Deadline
- Approved Institution
You also need to review these items each year. If there’s one thing about Tax Law, it changes constantly. Congress is good at this. They’ll change the rules every week. What they permit this year might be outlawed next year.
And once you open an account, don’t rely on your financial institution to tell you if you are still eligible next year. They will tell you that it is your responsibility to know the rules, and their telling you is only for your convenience. They are not liable, naturally, if you get tagged for an IRS penalty.
So, let’s take them one at a time:
Earned Income
Earned Income is simply defined as income you receive from the work you provide. So, the following types of income usually meet this requirement for a Roth IRA:
- Wages
- Salaries
- Job-Related Profit Sharing
- Sales Commissions
- Taxable alimony
- Tips
- Bonuses
If you are married and file a joint tax return, only one partner needs to have earned income for both to be able to contribute to a Roth.
Here are the types of income that are generally NOT considered earned income for Roth IRA purposes:
- Interest
- Dividends
- Capital Gains
- Rental Property Income
- Disability Payments
- Social Security Payments
- Pension Income
- Annuity Income
It’s pretty easy to get a gut feel for what income can be used to contribute to a Roth IRA. Of course, people come up with some interesting questions regarding earned income.
Look at it this way – if you had to actively do something to receive the money, you probably earned it. If you received the money without having to lift a finger, it is probably not earned income. It’s Active vs. Passive. You worked for it or didn’t.
What about Taxable Alimony? If you receive it, you’ll agree that you worked for it over the years!
Your Age
Currently there are no age limits or requirements to open an IRA. This is one area that needs to be checked each year. If the government starts to lose too much revenue, or too much money is being tax deferred by the public, this is one item that Congress will go after looking to change it.
Since there is no age limit, an interesting question comes up regarding your Kids. Theoretically, a 2 year old could open an IRA if he has earned income. People have tried hiring their 2 year olds for tax purposes, but naturally the IRS has gone after them and disallowed the deductions.
But what about a 12 year old who has a paper route? He can open a Roth IRA– You should encourage him to open a Roth IRA. Problem is twofold: You are the one who will have to convince the 12 year old to put part or all of his earnings in a Roth. And he will have full access to the funds when he turns age 18. Can you picture your trying to convince an 18 year old to leave the funds in the Roth for his retirement? Good luck!
Contribution Limits
The general rule is that a worker can contribute $5,000 to a Roth IRA in 2011. You can make an additional $1,000 contribution if you are over age 50 during 2011. Both of these rules are subject to the Income Levels below.
Income Eligibility Limits
The government doesn’t want highly paid workers getting too much of a tax deduction, so they impose Income Limits. There are 2 limits for Single filers and 2 different limits for Married filers shown in the table. If your earned income is under the lower limit, you can make the full $5,000 contribution. If your earned income is above the upper limit, you cannot contribute to a Roth IRA in 2011. If your earned income is in between the two limits, you can contribute a reduced amount (known as the phase-out limit).
You need to know that Income talked about here is NOT your Gross Income shown on your paystub. It is the Modified Adjusted Gross Income shown on your Form 1040. This is your paystub amount with a number of adjustments.
Just pull out your last year’s tax return and look at line 36. This is the amount used in the Income Limit calculation.
The Income Limit using Modified AGI income are:
2011 Roth IRA Income Limits
| Filing Status | Full Contribution | Reduced Contribution |
|---|---|---|
| Single /Head of Household | Up to $107,000 | $107,001 to $122,000 |
| Married Filing Jointly | Up to $169,000 | $169,001 to $179,000 |
For future years beyond 2012, the Roth contribution limit will increase at the rate of inflation in $1,000 increments, and the over 50 catch up limit will rise in $500 increments.
Contribution Deadline
Deadline for making a contribution is the same as your tax return filing deadline — April 15th of the year after you earned the income. Tax filing extensions do NOT extend the Contribution Deadline.
Opening an Account at an Approved Institution
Your Roth IRA must be opened at an IRS approved institution. Just about all the financial institutions you can think of are approved. These include local Savings banks, Commercial Banks, Brokerage firms, Credit Unions, Savings & Loan associations, and other FDIC-insured financial institutions. You can also open a Roth IRA online at most of these institutions or at an Online Bank. Read: Choosing the right Manager for Roth and Traditional IRA Investments
Making it More Complex
It may seem that the Income and Contribution rules to open a Roth IRA are pretty easy to understand. And they are, if you don’t care about getting a tax deduction for you contribution this year. You might be eligible to open a Traditional IRA and make your contribution tax deductible. That brings in a whole new set of Income Limits and Rules. So, you really need to read up on some other IRA subjects so you have a good feel for both Roth IRA’s and Traditional IRA’s.
Read these articles:
Act, Save and Enjoy Retirement
Opening a Roth IRA is one of the best ways to save for retirement since your withdrawals will be tax free. You’ll need to understand both Roth and Traditional IRA’s so that you can put the whole puzzle together.
The most important thought is to start early. Open an account for yourself, your spouse, and hopefully your kids. You’ll be quite happy you did later on.