October 8, 2009

Can you open a Roth IRA?

A while ago a relative of mine had to pay a tax penalty since he had setup an IRA when he didn't qualify to do so. I setup my Roth IRA with a discount broker without having to give them details on my eligibility. There doesn't seem to be any checks or tests to see if you're actually eligible to have a Roth IRA before you setup one with your broker. So there doesn't seem to be anything stopping someone from creating a Roth IRA when they really aren't eligible. An individual could setup a Roth IRA even though they aren't eligible and then end up facing a tax penalty. So its important that you make sure you're eligible for a Roth IRA before you set one up.

It seems to be common advice to setup a Roth IRA for a child. But a child isn't usually eligible to have a Roth IRA because they don't have compensation.

The rules for Roth IRAs are laid out by the IRS.

The two requirements to be eligible to contribute to a Roth IRA are:

  • Have taxable compensation.
  • Earn less than $116,000 for single or $169,000 for married.
The vast majority of people earn less than the income limits so that doesnt' disqualify many people. The other requirement of having taxable compensation is something that more people might not meet. This is what would make children ineligible in most cases.

What exactly qualifies as taxable compensation? Taxable compensation is defined by the IRS in the traditional IRA descriptions.

Taxable compensation includes:
wages, salaries, etc.
self-employment income.
alimony and separate maintenance.
nontaxable combat pay.

but does NOT include:
earnings and profits from property.
interest and dividend income.
pension or annuity income.
deferred compensation.
income from certain partnerships.
any amounts you exclude from income.

Furthermore the amount you contribute to your Roth IRA is limited by the lesser of your taxable compensation or the contribution cap. So if you have say, $3,000 in taxable income then that is lower than the normal $5,000 limit and you're only able to contribute the $3,000 lower amount.

Bottom line: Make sure you are eligible for a Roth IRA before contributing to one and a key eligibility requirement is having taxable compensation.

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