Roth IRA Questions Answered

After my post on Roth IRAs, I received a bunch of questions about the practical aspects of setting up a Roth IRA.  Here are, to the best of my abilities, the answers!  First: questions from people who already have some investments.

1) I already use a different brokerage.  Can I buy Vanguard mutual funds?
Senator William Roth

Maybe!  What you can invest in is completely up to your brokerage.

Virtually all brokerages offer Vanguard funds, but most charge a transaction fee.  For Fidelity, they hit you for $75 a transaction; at E*Trade, it's 'only' $20.  Schwab hits you with a $76 transaction fee and only accepts subsequent investments in $500 chunks (versus $100 at Vanguard).

You can research and compare all of Vanguard, Fidelity, E*Trade, and Schwab offerings here:

Vanguard - https://personal.vanguard.com/us/funds/vanguard/all?sort=name&sortorder=asc
Fidelity - http://personal.fidelity.com/research/funds/
E*Trade - https://us.etrade.com/investing-trading/mutual-funds
Schwab - http://www.schwab.com/public/schwab/investing/accounts_products/investment/mutual_funds

Vanguard is the industry leader and offers the lowest expense ratios and the best customer service.  You should only go somewhere else if you have a very good reason for doing so.

2) I have a retirement account from an old job / a brokerage account with some stock I bought a few years ago / a bond fund from grandpa; can I transfer them into a Roth IRA?

If you have existing financial instruments (stocks, bonds, funds, &etc) in a taxable brokerage account, you can't transfer them directly into an IRA.  To move that money into an IRA, you would need to sell the assets, pay capital gains taxes on the earnings, then contribute the money to the IRA.

If you have an existing retirement plan, this can be 'rolled over' into an IRA.  Rollovers do not count toward your contribution limit for the year.  This is not a taxable event, though the company currently holding the plan account may charge you a transfer out fee anywhere from $25-125 (call them and ask!).  Once rolled over, you can keep your existing holdings and/or invest in anything you could with a regular IRA at the brokerage you've rolled it into.  If your retirement account was a pre-tax plan, the rollover will create a pre-tax IRA.  Pre-tax IRAs don't allow you to withdraw the principal at any time and don't offer a first-time homebuyer provision on earnings withdrawals, but you can convert this to a post-tax Roth IRA by paying income tax on it.  See IRS Pub 590 for details, and don't be afraid to talk to your brokerage about tax consequences - they (like me!) can't advise you what to do, but they can help you figure out what will happen if you do something.

3) I know that I can always withdraw the principal in a Roth IRA, at any time and for any reason, without taxes, fees, or penalties.  Under what conditions can I withdraw the earnings?  If I invest in a 'Target Date' retirement mutual fund, does the money have to remain in the fund until the target date?

The Target Date retirement funds are just product marketing - as mentioned in the previous Roth IRA post, they consist of a mix of other funds and the asset allocation is automatically adjusted as you near your target retirement date.  You can move money in and out of a Target Date fund just like you can with any other mutual fund.

Once you reach age 59.5, all of your Roth IRA earnings withdrawals are 'qualified' and you pay no taxes or fees.  Withdrawals are also qualified if (see IRS Pub 590 for more details):
  • You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
  • The distributions are not more than the cost of your medical insurance due to a period of unemployment.
  • You are totally and permanently disabled.
  • You are the beneficiary of a deceased IRA owner.
  • You are receiving distributions in the form of an annuity.
  • The distributions are not more than your qualified higher education expenses.
  • You use the distributions to buy, build, or rebuild a first home.
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.
If you, your children, grandchildren, parents, or grandparents are buying a home and have not owned one for at least two years, you may withdraw up to $10,000 in Roth IRA earnings.  This 'first-time homebuyer provision' is a lifetime limit, so it is used up once you've withdrawn $10,000 in total.

If you withdraw earnings for a reason not covered by the Roth IRA guidelines, you are making an 'unqualified withdrawal'.  You will pay income taxes and a 10% penalty tax on the earnings you withdraw.

4) When investing in a Roth IRA, what do I need to keep track of for tax purposes?  Do I get any tax breaks?

Investing in a Roth IRA is not a taxable event, because you are investing money that you have already paid income tax on.  The IRS does want to make sure that you stay within the contribution limits, especially if you have multiple IRA accounts at multiple brokerages (which is 100% allowed), so each brokerage will send you IRS Form 5498 with the year's contributions.

If your income is sufficiently low, you may be eligible for the Qualified Retirement Savings Contributions Tax Credit.  To find out for sure, read the official IRS instructions and fill out IRS Form 8880.  You are not eligible if you make more than $28,750 (filing single) or $57,500 (filing joint), you are a full-time student, or you are claimed as a dependent on someone else's taxes.  The tax credit increases with IRA contributions up to $2,000 and may be as large as 50% of your total contributions, depending on your income.

5) You need earned income to contribute to a Roth IRA.  Does it matter what, exactly, the source is of the particular money you use to finance the account?

Nope!  As long as you have sufficient earned income, you're welcome to fund your account from any source you want.  In fact, someone else is welcome to gift you the money by contributing to your account for you.  The annual gift tax reporting limit is now over $18,000, so they could contribute up to the IRA maximum without even needing to record or report it anywhere.  If you have a kid and they have earned income, it's not a bad idea to teach a valuable lesson by instituting 'matching' contributions to their own account today.

Have more questions?  Ask them in the comments!