Roth IRA proponents are often heard to remark that one of the benefits of a Roth IRA is that first-time home buyers can withdraw up to $10,000 penalty free to use toward the purchase of their first home.  Those who are considering such a move should be made aware that the government’s definition of “first-time home buyer” also includes anyone who hasn’t owned a home in two years or more.  So, even if you’ve owned a home before, you can withdraw up to $10,000 from your Roth IRA to help meet qualified home acquisition costs.  And, the “first-time home buyer” doesn’t even have to be the owner of the Roth IRA; it can be the owner’s spouse, child, father, mother, grandfather, and grandchildren. 

$10,000 and only $10,000

Of course, the fact that the Roth IRA distribution can be used by so many different people does not mean that each person can get $10,000.  The limit of the distribution is $10,000 for the lifetime of the account owner.  Married couples who each own a Roth can take $10,000 each from their account.  I suppose that’s good news for someone who is an only child, and each parent owns a Roth; not such good news for a family with eleven children and just one Roth.

Qualified Acquisition Costs

The distributed funds must be used for expenses directly related to home acquisition: costs related to buying or building a home, plus any usual and reasonable settlement, financing, and closing costs.  You can’t use the funds to pay toward a home you already own and expect to do so penalty-free.  Mortgage repayment is not a “qualified acquisition expense”.  You can’t use the funds to buy furniture or for home repairs.    The Roth IRA funds distributed must be used before the close of the 120^th day after the distribution. 

Distribution Ordering Rules

First-in-first-out does not apply to disbursements from a Roth IRA.  In most cases, money is deposited into a Roth, interest is earned, more money is deposited, etc.  The money does not come out in the order that it was added to the account.  The first money to come out of a Roth IRA is taken from your contributions, regardless of when the contributions were made.  Next out would be money that you converted from a traditional IRA, lastly money that was earned.  

The key to using Roth IRA funds for home acquisition is to plan early.  Make sure the funds will be used within the 120 day time allotment, are used for a qualified acquisition expense, and make sure the funds taken will not be penalized or taxed.  If funds will be taxed, be sure you know how the taxes will be paid.

The tax cuts that were implemented by the George W. Bush administration are set to expire at the end of 2010.  The daily sound bites and media buzz lead one to believe that only the top tax brackets will be affected if these cuts expire.  That is not the case at all: if the tax cuts expire, all tax-paying Americans will be affected, some more than others.

The six tax brackets implemented under Bush were 10%, 15%, 25%, 28%, 33%, and 35%.  According to the Internal Revenue Service, less than 1% of taxpayers pay the 35% rate and less than 33%of taxpayers pay the 33% rate. Currently, most taxpayers are paying a marginal rate of 15% or 25%. 

If the Bush cuts expire, the six marginal tax rates will be replaced with 5 rates: 15%, 28%, 31%, 36%, and 39.6%.  The new rates translate to a tax bump from a few hundred to a few thousand dollars for most taxpayers. Regardless of your tax bracket, the expiration of the Bush cuts means that Americans will face higher tax rates, more taxes on investment income, fewer tax breaks for families, and a tougher estate tax.

Avoid Higher Taxes on Your Retirement Funds

Investors who have money in a traditional IRA will certainly pay more taxes on withdrawals in 2011 than in 2010.  So, why wait to until 2011 or beyond to start withdrawing funds?  In 2010, traditional IRA owners can roll their IRA over to a Roth IRA without income limits and other restrictions.

Now is the Time to Convert

There are three main reasons to convert a traditional IRA to a Roth IRA in 2010:

1. Investors can “lock in” the current tax rates and not risk the possible tax increase
2. There is a three-year window on paying the taxes due
3. Income limits are removed

Positive Side-effect

The removal of income limits to a Roth IRA provides a side effect that hasn’t gotten much press: national deficit reduction.  To convert from a traditional IRA to a Roth IRA entails paying taxes now that would not have been paid for years to come.  Investors who pay the conversion taxes now are able to permanently free their retirement income from taxation. The combination of benefits provided by conversion is so compelling that Americans are converting in large numbers, and will continue to do so through the end of the year.  The “pre-payment” of hundreds of billions of dollars in taxes will help reduce the federal deficit and get the American economy back on track.

Many investors have a false sense of security when it comes to keeping track of contributions to their Roth IRA.  It is assumed that the brokerage or bank is keeping adequate records, and that copies of the records will be readily available if they are needed.

Such is not always the case.  As a CPA recently wrote:  

‘I’ve prepared too many tax returns where no one knows what their basis is – in their retirement funds, or in their taxable accounts. Brokers are not always very helpful. They don’t necessarily keep records forever, either. (and) with all these investment house mergers, past data does not always carry over to the new firm…I see a lot of people get “double taxed” as a result. Particularly when it comes to IRAs that have basis in them’

Keep Your Own Records

Typically, one keeps financial records for seven years, for tax purposes.  In the case of tax-deferred investments, it is recommended that records be kept until seven years after the investment has been liquidated.  If the Roth IRA is to be passed on to heirs, that means keeping the account records beyond death.

The primary reason to keep the records that long is the issue of basis.  Basis is what you have contributed to the account, as opposed to what you have earned on the account.  In a Roth IRA, the basis is not taxed upon withdrawal.  Depending on the purpose and timing of a withdrawal, earnings may or may not be taxed.  Either way, it will be necessary to know your basis.

5 Reasons to Keep Your Own Records

There are five compelling reasons to consider keeping your own Roth records.  They are:

1.  Tax laws are subject to change: it’s good to have proof of your IRA contributions and conversions.  Keep the conversion tax forms indefinitely.

2.  If you change custodians: when you change custodians you could lose all cost basis information held by the original custodian

 3.  Inheritance taxes:  Basis changes from generation to generation.  Having a complete account records provides a chronology of the account.

 4.  Support legal action: in these days of corporate bailouts and bankruptcies, contributions could be lost and then recovered in a lawsuit.  

 5.  Differing state tax laws: sometimes state tax law differs from federal law.  Just because withdrawals are untaxed at the federal level does not mean they will be untaxed by your state.  

 CPA’s recommend that you keep your records in a fire-resistant box.  When you have reviewed your monthly statements, file them away, and keep the box in a safe place.

A Roth Individual Retirement Account is a unique type of savings plan that will help you set aside adequate amount of money for retirement that you would otherwise recompense in taxes. There are several factors that you should familiarize yourself with prior to housing your money in a Roth account. Keep in mind that this account is not available to all soon-to-be retirees and they are supervised under strict rules and regulations.

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