What is a Roth IRA?

by Jason on July 20, 2009

No doubt most people have heard of a Roth IRA, after all, they’ve been around since 1998.  Although they’ve been available for over 11 years, I’m constantly amazed by how many people are just simply unsure of exactly what they are or what they do.

Tax Shelters

The Basics: What is an IRA?

An IRA is simply an Individual Retirement Account (IRA) that provides investors an opportunity to save for retirement in a tax-advantaged way.  Generally, you must wait until 59 1/2 to withdraw the money without IRS penalty.

A Roth IRA is an Individual Retirement Account named after its legislative sponsor, late senator Bill Roth, that was established in 1998 to provide an alternative method of saving for retirement that offers different tax advantages than the Traditional IRA.

Features

The main difference between the Traditional and the Roth IRA is how it is taxed.  With a Traditional  IRA, you typically contribute before-tax (with some exceptions) money to the account.  Depending on your eligibility, you can deduct your contributions from your income on your current year taxes.  You receive the tax break now.  The money grows tax-deferred so when you pull your savings out in retirement you have to pay taxes on every single dollar you withdraw at whatever your current tax rate is at the time.

The Roth IRA is just the opposite.  You contribute after-tax dollars to the account and the money still grows tax-deferred.  You cannot deduct your contributions; however, in retirement you can withdraw your money (provided you meet certain qualifications) completely tax free. Not only that, but as long as your Roth IRA has been in existence for five years, your beneficiaries on the account can pull out money income-tax free, so the Roth IRA becomes a nifty estate planning tool as well.

Advantages

1. Obviously the biggest advantage to the Roth IRA is the tax-free withdrawals in retirement.  This can be a huge potential tax savings for you especially if you think tax rates will be going up.

2. The Roth offers more flexibility on withdrawals prior to retirement.  You can withdraw your principal (your contributions)  tax and penalty free at any time during the life of the Roth IRA.  To an undisciplined person might have trouble with this, but someone who runs into a bind an is cash strapped can have a little comfort knowing they have some additional money available.  This is a huge plus compared to the Traditional IRA, where you would pay a 10% penalty on any pre-59 1/2 withdrawals as well as taxes.

3. Another advantage is that you can contribute to the Roth even if you are covered by an employer-sponsored retirement plan (401k etc).  With the Traditional IRA you are subject to income testing to determine if you could contribute when covered already by a plan  at work. Even if you could contribute, you don’t get to take advantage of the deduction on your taxes.  So the Roth becomes the perfect additional savings plan when you already have a 401k or other employer plan.

4. For older folks, the fact that you do not have to take withdrawals is a major advantage as well.  With a Traditional IRA, the government forces you to take money out at age 70 1/2 or face a 50% penalty for not withdrawing your savings.  The main reason is of course to generate tax revenue.  Since Roth IRA distributions are tax free, you don’t have to worry about this rule.

Key Tradeoffs

1. Your contributions are limited.  Currently in 2009, you may only contribute $5,000 and if you are over 50 you can contribute an additional $1,000 for a “catch-up” provision.  Depending on your income, you might be phased out of your contributions.  For example, a couple making between $166,000 and $176,000 will have their contributions limited.  Income over $176,000 disqualifies you for Roth contributions altogether.  Try this online calculator to determine how much you can contribute to a Roth.

2. You still might have to pay taxes on non-qualified distributions.  In order to meet the specifications for a qualified distribution, you must have had the Roth opened for at least five years and meet one of the following:

  • Reached age 59 1/2 by the time of the withdrawal
  • Withdrawal is due to qualifying disability
  • Withdrawal is made for first-time homebuyer expenses (up to $10,000)

Again, you are still able to withdraw your contributions at any time without penalty or taxes.

3. Tax treatment differs depending on the state.  The tax laws mentioned above correspond to federal law.  Your state may have differing laws for Roth IRAs You should check with your tax advisor to ensure you won’t have to pay state taxes.

How Do I Get One?

You can open a Roth IRA through any financial institution, bank, life insurance or mutual fund company or even right online through a brokerage website.  Where you establish one primarily depends on your own needs and preferences.  There are many investment options available as well, so consider the types of investments that will suit your needs (i.e. stocks, funds, CDs, ETFs etc).

Contributions must be made by the time you file your tax return. So in essence you have until April 15 of the following year to get your Roth contributions in for the previous tax year.

The Roth IRA can be a great investment and retirement savings vehicle for many people.  Be sure to do your homework, develop a plan, assess your needs and be comfortable with your decision.

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