What is a Self-Directed Roth IRA?
A self-directed Roth IRA functions the same way as a traditional self-directed IRA account. The differences between a traditional self-directed IRA and a self-directed Roth IRA mainly deal with taxation. In a traditional IRA account, your contributions into the account are tax deductible. The government instead charges you taxes when you withdraw the money – so all the investment returns generated inside the IRA account are taxed when you take the money out.
With a Roth IRA, you make contributions into the account with ‘after tax’ money – so when you make contributions into a Roth IRA you are not able to write them off. The trade off is that all the investment returns generated inside your Roth IRA are tax free.
For self-directed IRA investors this can be an extremely powerful tax strategy. Most self-directed IRA investors expect to outperform the returns they were able to generate in their old IRA. After all if they didn’t what’s the point of setting up a self-directed IRA?
Contributions to a Self-Directed Roth IRA
The contribution limits are the same for traditional and Roth IRAs, the difference is that if you make too much money, you might not be eligible for a Roth IRA – or possibly only eligible for a reduced contribution. Here are the income restrictions for 2012 as set forth by the IRS:
If you are a single filer you are allowed the full contribution for 2012 of $5,000 if your income falls below $111,000.
If you make more than $110,000 your ability to contribute is reduced through IRS guidelines until your income hits $125,000. If you make more than $125,000 you are not allowed to contribute to a Roth IRA.
Married & Filing a Joint Tax Return
If you are married, and filing a joint tax return with your spouse, you and your spouse are each allowed to contribute $5,000 – so long as your combined income falls below $173,000.
If you make more than $173,000 your ability to contribute is reduced through IRS guidelines until your income hits $183,000. If you make more than $183,000 you are not allowed to contribute to a Roth IRA.
Catch Up Contributions
If you are over 50 years old, the IRS will allow you to make up to an additional $1,000 contribution into your Roth IRA (above and beyond the regular $5,000).
Withdrawals from Self-Directed Roth IRA
As with traditional IRA accounts, if you wish to withdrawal money from a Roth IRA before you reach the age of 59 1/2 you will be hit with a 10% early withdrawal penalty. In addition, you will be required to pay taxes on the earnings generated inside your Roth IRA. So if you invested $10,000 in a Roth IRA, and the balance grew to $12,000 (20% gain). You would have to pay taxes on 20% of whatever you withdrawal from your account. For example, if you wanted to withdrawal $1,000, you would have to pay taxes on $200. Since your initial contributions were made with after-tax money – the government doesn’t tax that portion. However, by making the early withdrawal, you are giving up your Roth benefits (which is avoiding taxes on the returns generated inside your IRA account).
Another difference between a traditional IRA account and a Roth IRA is that the government does not require you to start taking mandatory distributions when you turn 70 1/2. Since the government isn’t going to charge taxes on Roth IRA distributions at that point, they don’t care if you ever take the money out of the account.
Roth IRA Conversion
Converting your traditional IRA accounts into a Roth IRA account is possible, and may or may not make sense for you depending on your tax situation. The IRS has changed the rules for Roth IRA conversions, and there is now no income limit. No matter how much money you make, you are able to convert your traditional IRA accounts into a Roth IRA.
The catch is that you will be required to pay taxes on the entire amount you convert into a Roth IRA. If you plan to convert a $100,000 traditional IRA account into a Roth IRA, that entire $100,000 will be added to your ordinary income for the year – potentially representing a huge tax burden.
Depending on your age, tax bracket and expected investment returns it may or may not make sense for you to go through with a Roth IRA conversion. It is wise to seek counsel with a trusted CPA and/or financial advisor before proceeding with a Roth IRA conversion.
One other thing to keep in mind is that despite being allowed to convert to a Roth IRA, if you do not meet the income requirements for Roth IRA contributions, you will not be able to make additional contributions into your Roth IRA after the conversion is finalized.
Setting up a Self-Directed Roth IRA
Setting up a self-directed Roth IRA works the same way as setting up a traditional self-directed IRA. When you go to set up your new self-directed IRA account, just make sure to specify that the funds you plan on rolling into the account are Roth IRA funds. If you have both traditional IRA funds and Roth IRA funds, you will either need to create two separate self-directed IRA accounts, or you will need to convert your traditional IRA funds over to Roth IRA funds (see above for more details on converting to a Roth IRA).