Should You Open a Roth IRA?

by Jason on March 22, 2010

Tax Season is upon us and this time of year usually gets people thinking about funding IRA contributions for last year, which usually leads to a question of – which type of IRA is right for me?

Today we’re going to briefly talk about Roth IRAs.  There’s been a lot of talk about Roth IRAs this year because of the new IRS rules regarding Roth Conversions.

As always, no investment is right for every single person, but in the right scenario, Roth IRAs are a great retirement savings tool.

Let’s start with the basics:

Roth IRA vs Traditional IRA

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.

Under this section of the tax code, a Roth IRA is funded with after-tax contributions, which simply means you do NOT get a tax break up front.

With a Traditional IRA, provided you meet certain qualifications, which we’ll cover in a future post, you can deduct your contributions up front and get a tax break NOW.

So remember – at its very basic level, a Roth IRA gives you a tax break later

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Roth IRA Withdrawals Are Tax Free

You are funding a Roth IRA with after-tax dollars, 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.

What are the qualifications to make sure your Roth withdrawals are tax free?  Here’s a great little chart from the IRS website, publication 590.

Figure 2-1. Is the Distribution from Your Roth IRA. Taxable?

Income Limits

Limits, there’s always limits!

Here’s the deal with the income limits and phase outs for your contributions:

  • If you are married filing jointly your contributions are reduced if your modified adjusted gross income (AGI) is between $167,000 and $177,000. Beyond that – sorry! No can do.
  • If you’re a single filer, your contributions are reduced if your modified adjusted gross income (AGI) is between $105,000 and $120,000.  You cannot make a Roth IRA contribution if your modified AGI is $120,000 or more.

Some Things to Consider When Opening a Roth IRA

  1. When will you need the money? Remember, this is a retirement account – so ideally you want to put in the back of your mind that this is “post 59 1/2” money.  But, the nice thing about the Roth is that your contributions are available without tax or penalty, so if you do run into a bind you’ve got some money available.
  2. What is your tax status now? If you are in a low bracket now and are figuring that your income and therefore your tax bracket will be increasing in the future, then a Roth IRA makes a lot of sense because you’ll be pulling money out tax-free in a higher bracket giving you more advantage.  If you’re in a high bracket, remember that contributions to a Roth IRA do not reduce a taxpayer’s adjusted gross income (AGI).
  3. What will be your tax status in the future? Again, if you think that your tax bracket will be increasing, the benefit to the Roth looks even better;  if you think your bracket will be decreasing and your income will go down in retirement then you want to consider whether the Roth IRA makes the most sense for you.  It doesn’t mean you shouldn’t do it, after all – it’s smart to diversify yourself from a tax standpoint – just make sure you know what you’re getting into.

How Do I Open a Roth IRA?

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, 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.

What are your thoughts?

Readers, do you think the Roth IRA is a good idea or is it a trick by Uncle Sam to get more tax revenue up front?

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