The Roth IRA (individual retirement account) is one of the most misunderstood financial tools available in America. Named after its chief legislative proponent, Senator William Roth of Delaware, the Roth IRA came into being in 1997 under the Taxpayer Relief Act.
This form of IRA allows users to contribute money from their paycheck (after-tax). Withdrawals are then tax-free during retirement, meaning that the growth on your investments isn’t taxed. Because this account offers tax-free retirement income, it can be an extremely attractive option for participants who are likely to be in a higher tax bracket during retirement than they are in presently or who wish to spread out the taxation of their retirement investments. The fundamental difference between a Roth IRA and a traditional (or “Simple”) IRA is the time of taxation; Roth IRAs are only taxed before contributions are made, while traditional IRAs are taxed upon withdrawal.
As with all forms of retirement account, there are eligibility requirements which must be met in order to set up and then contribute to your Roth IRA. People above a certain income cannot contribute, much like a tradition IRA. This amount varies depending on your situation, but basically is (as of 2008):
Roth IRA Income Limits
Notice that people who are married but file separately (and live together) are generally not eligible for contributions, or only for a small amount. Do keep in mind that if you rise above the amount of eligibility, your previous contributions are still valid and remain a part of your Roth IRA account. You also may not contribute MORE than your taxable income for a year, if your income is below the maximum contribution.
Roth IRA Contribution Limits
Some of the advantages of Roth IRAs over tradition IRAs are:
- Taxation: Because a Roth IRA contribution has been taxed before it is put in, it may be worth as much as a larger contribution to a traditional IRA, which will be taxed upon withdrawal. If one assumes a 25% tax bracket, a contribution of the 2008 limit of $5,000 to a Roth IRA can be equivalent to a traditional IRA contribution of $6,667. Due to contribution limits you cannot add $6,667 to a traditional IRA so the post-tax Roth contribution may be larger in the long run. However, one must consider that many people end up in a lower tax bracket during their retirement, so they will not get as much of a benefit on this. Regardless of whether marginal tax rates increase or decrease, Roth IRA earnings are not taxed if you follow the withdrawal rules and do not incur penalties.
- Withdrawals: Unlike the traditional IRA, contributions you make directly into your Roth IRA can be withdrawn at any time, tax-free. Converted and rollover contributions can also be withdrawn without tax or penalty after a five year ‘seasoning’ period. Earnings and investment profits can be withdrawn penalty and tax free after the same seasoning period and age 59½ except in certain circumstances. Penalties can apply to early (before age 59 ½) withdrawals from a traditional IRA and any monies taken out are taxed as ordinary income.
- Home Purchase: If you, your spouse, your parents, or your children are buying a home, up to $10,000 in earnings withdrawals can be taken out tax-free. This house must be used by the purchaser as the primary residence and they cannot have owned a home in the last 24 month in order to qualify.
- Withdrawal Dates: Unlike all other tax-deferred retirement accounts, even the Roth 401(k), the Roth IRA does not require withdrawals to begin by April 1 of the year after the owner reaches age 70½. If, during your retirement, you don’t need the money and want to let it accumulate or leave it to your heirs, the Roth IRA is a great way to generate income tax-free.
- Contribution Eligibility: It is legal to contribute to a Roth IRA even if you already participate in a retirement plan such as a 401(k). You can also make contributions to a traditional IRA in this case, but they may not be tax deductible.)
- Tax Rate: The Roth IRA is advantageous to people who believe that the tax rate applicable to withdrawals in retirement will be higher than the tax rate applicable to the funds earned to make the Roth IRA contributions. Basically, if you think you’ll be paying higher taxes when you retire than you are now, a Roth IRA is a good way to circumvent that.
Any of you who would like to learn more about the Roth IRA and its full details should visit the government website dealing with Roth IRAs (publication 590) at the IRS page on the subject. Just be warned… It can be quite difficult to read and comprehend!
For the 2009 tax year, there were some changes made to the assorted IRA programs which have temporarily eliminated the requirements for withdrawal. The Worker, Retiree, and Employer Recovery Act of 2008 (the “WRER Act”) provides that owners and beneficiaries of IRAs will usually be able to leave their money in their plans without suffering any penalty for failure to withdraw in the hopes that retirement accounts will have some time to begin to recover from the market decline of the past year.
Tags: investing, IRA, long term, Retirement, savings
