Here’s a question about Social Security that I came across not too long ago:

I’m in my 60′s and am receiving Social Security every month.  How much, if any, can I still contribute to my Roth IRA?

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In other words, the question is  – Is Social Security income?  Or more specifically, is it earned income.  So here’s the answer:

Social Security Does Count as Income

Yes, Social Security is definitely income received.  However, it doesn’t mean it’s fully taxable.  To the extent that the IRS looks at your Social Security as income that must be included for tax purposes depends upon how much income you earn from other sources and your marital status.

In 2010, the IRS has base amounts of:

• $32,000 for married couples filing jointly
• $25,000 for single, head of household, qualifying widow/widower with a dependent child, or married individuals filing separately who did not live with their spouses at any time during the year
• $0 for married persons filing separately who lived together during the year

In other words, if you make more than the base amounts you must include Social Security as income for tax purposes.  To learn more check out Publication 915 from the IRS.

Social Security Does Not Count as Earned Income

Is Social Security income?  Not in the sense of earned income. Social Security income is not earned. In order to contribute to a Roth IRA (as the question asks) or a Traditional IRA, you must have earned income equal to the amount of your contribution.

Earned income includes:

• wages
• salaries
• commissions
• professional fees
• bonuses
• self-employment income, etc.

You could have income from any of these sources and contribute that earned income to a Roth IRA or Traditional IRA.

The max contributions for 2011 are $5,000 per individual under age 50 and $6,000 per individual if over age 50.

The Answer to the Question

The answer to this question is, “It depends.”  It really depends if this individual is receiving any type of earned income.  If so, then they can contribute any amount of that earned income up to $6,000.

If Social Security is their only source of income, then the answer is no, they cannot contribute to a Roth IRA.

Have a Question?

Contact me with your questions. Yours could be included in the next blog post!

What is diversification?

Merriam Webster defines it as giving variety to something.

Variety is good. 

It’s good in life, in business, and particularly with our savings.

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The idea of diversifying has been around a long time.

With today’s market volatility, it’s increasingly important to answer the question – what is diversification – through the use of four different lenses.

An acronym is helpful to understand the lens:

What is Diversification from the P.I.T.T.?

1. Product

What is diversification of products?

Diversification of products simply means that you utilize a variety of investment vehicles.

Some products offer guaranteed rates, others offer guaranteed income (with fees of course).

Other products offer downside protection. 

Products are designed with different functions.  It’s important to have a variety of products when it comes to our retirement savings.

2. Investment

What is diversification of investments? 

This means you diversify across asset classes with stocks, bonds, and alternative investments.

You also want to look at diversifying within those asset classes both by different types of stocks, but also diversifying with numbers of stocks.

An example of diversifying within asset classes would be choosing defensive positions during difficult times like dividend-paying stocks, consumer staples, or precious metals.

This is a key to adding additional returns during difficult markets.

3. Time 

How do you diversify through a time lens?

This means you have short, medium, and long-term investments.

If you have an emergency fund and something happens to your job, you won’t have to take an early IRA withdrawal.

You will be able to weather that storm because you’ll have short-term investments.

Some products with guarantees may have time schedules that you must keep to avoid charges.

Having shorter term investment money is a wise diversification move.

4. Tax

What is diversification for taxes?

Diversification from a tax standpoint means that you work at balancing tax deferred, “taxed now”, and tax-free accounts.

In other words you intentionally build tax-deferred assets like IRAs and  401ks.

You also think about building regular brokerage accounts or what would be called non-qualified money.

And lastly, you think about building tax free money with a Roth IRA or Roth 401k.

Following these guidelines does not insure investor success, however, diversifying your savings from these standpoints can help reduce risk and generate more consistent returns over the long run.

As always, be sure to consult with a tax advisor when making tax decisions.

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Readers, post your comments:

• What is diversification to you?
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• What other diversification have you done (like income?)

We all know that saving money is really the key to building long-term wealth.  Just this week, I was reading an article by Mark Cuban, discussing how to create real wealth.  Right now Mark Cuban is a really happy guy.  He is the outspoken, charismatic owner of the Dallas Mavericks, and if you weren’t aware, the Dallas Mavericks just humiliated Lebron James and Dwayne Wade in the NBA Finals.

Mark’s primary advice for creating real wealth was simple—save money!  Creating wealth doesn’t happen overnight.  It happens over time, and investing your money intelligently can be huge key to building long-term wealth.  In this article, we are going to discuss an alternative retirement investment vehicle, the Roth IRA.

What Is A Roth IRA?

First of all, the Roth IRA is not really an alternative retirement investment.  I simply call it alternative because it’s not nearly as well known as its more mainstream counterpart, the 401k.  The 401k, of course, is the common retirement account that most employers in America offer employees.  A Roth IRA, however, is a retirement account that you must set up yourself either online through a broker, or through an investment advisor.

The primary advantage of a Roth IRA is that the money you invest accrues tax-free, and you are also able to withdraw your investment gains once you reach retirement age without paying ANY tax!  That is an incredible advantage.  Now, the 401k differs from the Roth because with a 401k, an investor invests pre-tax dollars.  However, when an investor then wants to withdraw money during retirement, he or she will have to pay income tax on that money at their current income tax bracket.

The Roth IRA differs significantly.  With a Roth IRA, an investor invests after-tax dollars, which is why he or she pays no tax when funds are withdrawn in retirement.  If a person wants to withdraw money before retirement age to give a friend or family member a cash loan or a working capital loan, he or she will have to pay substantial fees.  Therefore, it is best to keep this money in the account until retirement unless needed for absolute emergencies.

Traditionally, most investors simply open an account with an investment advisor such as T. Rowe Price or Vanguard, and investment decisions are made for him.  A self-directed Roth is a great option for the more active investor.  If you want to personally manage a percent of your net worth, you can open a self-directed Roth IRA through a popular broker such as TD Ameritrade or E*Trade, and you can then actively manage those investments.

Roth IRA Contribution Limits

This is the major disadvantage of a Roth IRA.  The U.S. government has strict max contribution requirements in place.  If you are interested in a Roth IRA, check with an investment advisor or a broker to find out the most recent regulations.  Generally, a person is allowed to contribute several thousand dollars per year to a Roth IRA, but it depends on a person’s annual earnings.  If you earn too much, then you may not be able to open a Roth IRA.  Again, these regulations tend to change rather frequently, so, just as when you are shopping for a cash loan or a working capital loan, consulting with a professional investment advisor is the best thing to do.

What Can You Trade With A Roth IRA?

The beauty of the self-directed Roth IRA is that it is very flexible.  Currently, you are able to trade stocks, futures, options, and currencies.  Remember trading financial markets carries a significant risk of loss, so make sure that you are always trading risk capital.

This has been a guest post by Jason Hoerr, who began his career as a trader in the most unlikely of places. As a high school English teacher, he was introduced to the concept of trading the forex market one day by the Principal at his school. Drawn by both the intellectual challenge and the opportunity to make money, he immediately began researching and learning everything he could about
currencies, economics, and trading. As his passion for the forex market grew, so did his desire to trade full-time. As his track record continued to grow, he began receiving requests to manage client funds. Today, Mr. Hoerr is trading full-time from his home office in Charlotte, NC.

For as long as I can remember, people in the so-called middle and lower classes (as far as income is concerned) have always felt that the “rich” have far too many tax breaks. They point toward those wealthy individuals who are able to retain a significant portion of their income through various income tax deductions and credits (which serve to reduce your taxes).

With the US economy in the toilet for the last few years, these talks of unfair tax breaks for the wealthy have been getting much more prominent.

However, what many people fail to recognize is the fact that many of these same deductions and credits are available to taxpayers of all income levels. Here are a few ways in which you can reduce your taxes, just like the rich!

So let’s look at how to reduce your taxes like the wealthy!

Giving To Charity

Donating money to a charitable organization is one of the most common ways that the wealthy reduce their tax bill. You don’t have to make it on the cover of the next Philanthropy magazine in order to make an impact. Just be sure to receive a receipt for any donations that you make to your local church, or food bank and deduct those amounts from your taxable income. Even if you are just giving to the poor – as long as it’s through a charitable organization – will give you an additional tax deduction!

Also, include any donations which you may have made to disaster relief efforts and other 501(c)(3) organizations (such as foundations connected to educational institutions, medical research, etc). In this case, you are able to reduce your taxes by helping others!

Owning A Home

There are two ways in which you can benefit from “owning” a home.

Take Out A Mortgage

I think it’s becoming a pretty well-known fact that I hate mortgages. However, they do carry tax benefits to them. If you have a mortgage, then you are allowed to deduct both the interest paid against the loan and the property taxes paid during the tax year, from your income. For those of you who have looked at your statements, you know that these amounts can be quite large (especially if you live in New Jersey)!

Own Rental Property

Another way in which the “wealthy” are able to mitigate some of their tax liability is to purchase rental property. All expenses that are incurred in both the improvement/renovation and maintenance of your rental property can be deducted from your income. Don’t forget to include the costs for advertising, property management, legal fees, and even travel related to your rental property!

If you take out a mortgage on your rental property, then you are able to deduct both the interest and property taxes as well, and reduce your taxes even further.

Start A Business

This is probably how the majority of non-celebrity wealthy people established themselves. For most people reading this article, quitting your job to start a business is probably not feasible (it surely isn’t for me)! However, you can easily take a hobby and turn it into a side business.

You can give lessons, offer services, or even create various products, and all without turning your life upside down! You may even want to create a website or start a blog as part of your business.

No matter what you choose to do, any expense related to this business will be tax deductible. With the ability to capitalize certain expenses, starting a business would be a great way to manage your tax situation. If you decide to pay yourself, make sure you are aware of the self employment tax rate.

Invest In Tax-Friendly Accounts

The key here is to get to a point where you can gain a significant portion of your income from income from your investments. Most municipal bonds are exempt from both state and local taxes, and so they are a favorable investment – especially in states that have high tax rates!

If you are looking to save on your tax bill today, then look no further than either a Traditional Individual Retirement Arrangement (IRA), or a 401(k). Both of these accounts allow you to defer your taxes until the time in which you begin to take distributions (up to age 70 1/2). This means that the money you put into these accounts today will not be taxable (up to the limit).

If you desire to gain huge tax savings in the future, you can look into either the Roth IRAs or Roth 401(k)s. What’s special about these accounts is that unlike their “traditional” counterparts discussed above, you pay taxes on the contributions in the year that you make them. However, once you are ready to take your distributions, no taxes are owed.

If you are able to take large enough distributions in order to support yourself, then you will greatly diminish your tax liability.

Take a look at the IRA contribution limits and 401k contribution limits and reduce your taxes!

Nothing Special

As you can see, all of the items listed above can be accomplished by taxpayers of most income levels. You will also notice that these are not earth-shattering, secret financial gems known only to a few!

On the contrary, these are situations that millions of Americans find themselves in every day. The only difference is that many of us don’t realize what a huge difference these overlooked tax deductions can make in our tax liability. If you have not yet completed your tax preparation, then take a look at your finances to see if you are already taking advantage of some of these techniques.

photo by Arvind Balaraman

Reader Questions

1. What situation in your life gives you the largest tax benefit (mortgage, marriage, children, business, retirement accounts, etc)?
2. Do you consider your tax situation before making certain financial decisions?
3. What is the one tax code you would change?

So we are about halfway through 2010!  Hard to believe isn’t it?

Although some of the buzz has seemingly died down about the year of the Roth IRA Conversion, there is still some controversy regarding whether folks should convert their Traditional IRAs to a Roth.

For those of you wondering what exactly is a Roth IRA,  Well, here are the basics:

A Roth IRA is funded with after-tax contributions; the money grows tax-deferred; and withdrawals are TAX FREE!

In other words, you use money you’ve already paid taxes on to fund the Roth, and provided you meet certain qualifications you never have to pay taxes on that money again!

What is a Roth IRA Conversion?

A Roth IRA conversion then is withdrawing money from a Traditional IRA and putting it into a Roth IRA where it will grow tax free.

Sounds good right? 

Well, the problem is that whenever you do this you have to pay taxes on the amount you withdraw from your Traditional IRA. 

So, let’s say you are converting $5,000 from your Traditional IRA — you would have to tack on 5G’s to your income for the year and pay tax at whatever rate you are at.  It’s as if you earned an additional $5,000 of income for the year.

As many of you already know, one big change for 2010 is that anyone can convert to a Roth regardless of income level. Previously, if you made over $100,000 you could not convert to a Roth.

If you convert in 2010, you now have a choice to pay all of your taxes in 2010 or average the taxes owed on the conversion over two years (i.e. pay in 2011 and 2012).  Uncle Sam is giving you a choice on when you pay your taxes.

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Don’t forget though that 2010 is the last year for the current low income tax rates. The current law plans for higher tax rates in 2011 — so, if you chose to average your tax payments over the two year period in 2011 and 2012, you might get hit with higher tax rates.   That Uncle Sam – he’s always got an angle doesn’t he?

Should You Do a Roth IRA Conversion?

Back to the question at hand.  Should you perform a Roth IRA Conversion in 2010? 

Usually the answer to such questions is “it depends”.  This might be a great year to convert your money to a Roth and potentially pay lower taxes than you would normally if you are in a lower bracket due to retirement or a layoff and you’ve got some cash on hand to cover your taxes! 

This is important because if you are under 59 1/2 and use your IRA to pay the taxes on the conversion you’ll get whacked with a 10% penalty on top of the taxes!

Let’s take a look at some things to consider:

Factors to Consider for Your Roth IRA Conversion

• Do you have money to cover your tax liability?  Having cash on hand to cover your taxes will help soften the blow, and you certainly don’t want to pay taxes with the money you are converting.
• Will the money you convert push you into a higher tax bracket?  If so, you probably don’t want to do it.
• Do you have non-deductible contributions in your IRA?  No taxes are due on the non-deductible portion.  *There are some additional factors about non-deductible IRAs that I covered in a post at Bible Money Matters.
• Are you planning on applying for financial aid for yourself, your spouse or your child?  Better think twice about the conversion – conversion income counts on your application.

Ultimately, whether you convert your Traditional IRA to a Roth will not determine your retirement success, there certainly are other things to consider to help you make a great run at retirement. 

So which retirement account is right for you?  Consider the above  factors, your overall situation and the Roth IRA conversion rules to determine whether the Roth IRA conversion makes sense for you in 2010.

This was a post I originally wrote for ChristianPF.com and adapted here for my site.

Retirement is a fascinating topic don’t you think? 

Millions of people long for it, plan for it and obsess over it.

On a daily basis, people ask themselves questions like these:  when can I retire?; how much money do I need to retire?; and which retirement account should I be saving into as I get ready for that big day?.

The last question is what we want to tackle today – which retirement account is right for you?

We certainly won’t cover every single type of retirement account out there today, but I do want to tackle the big four – 401ks, Traditional IRAs, Non-Deductible IRAs & Roth IRAs to see which one(s) make sense for you.

Let’s take a look:

401k Retirement Account

401k legislation was written in 1978 and finally passed in 1980.  401k’s allow employees to choose to receive deferred compensation rather than direct compensation.  That compensation gets put into a 401k account that is invested.

401ks are tax-deferred retirement savings accounts.  Basically they allow you to reduce your taxable income, which gives you a tax-break now.

They also grow tax-deferred – meaning you are not taxed on the growth of the investments each year.

When you pull the money out in retirement, however, you must pay the Piper!  Uncle Sam will ask for all that deferral to be taxed.

Every dollar you pull out will be included in your taxable income for the year – it’s as if you earned that money. 

401ks – The Right Retirement Account for You?

401k retirement accounts are right for folks who like having an easy way to save for retirement (deductions are taken from your payroll), who want to reduce their taxes now and who are getting an employer match on their 401k contributions.

Traditional Individual Retirement Account (IRA)

A Traditional IRA works much the same way as a 401k except for the payroll deduction.  The limits are much lower in terms of what you can contribute as well.

If you are covered by a retirement plan at work and making between $56,000 and $66,000 for singles and $89,000 and $109,000 for joint-filers then the deductibility of your contributions are phased out.

That means you cannot deduct the entire amount of your contributions from your income. 

If you are making under that amount or you are not covered by an employer retirement plan at all, then you are able to fully deduct your IRA contributions.

Traditional IRAs – The Right Retirement Account for You?

A Traditional IRA is a great retirement account for those who may not have a 401k or other employer plan, or who perhaps do have one, but are making less than the phase-out limits and want to get tax advantages now.

Roth Individual Retirement Account (IRA)

Roth IRAs are Individual Retirement Accounts that do not give you a tax break up front.  Rather, they allow you to put in after-tax money, which then grows tax-deferred.

When you reach 59 1/2, you can take out your contributions and your earnings completely tax-free!

Like the Traditional IRA, the IRS has phase out rules for Roth IRAs.  For single filers, your Roth IRA contributions are phased out when your Modified Adjusted Gross Income (MAGI) is between $105,000 and $120,000.  Above $120,000 you are ineligible for a Roth IRA contribution.

For married filers, the phase-out limits are between $167,000 and $176,000 and above that you are ineligible for contributions.

Roth IRAs – The Right Retirement Account for You?

Who should open a Roth IRA?  Basically anyone who falls under the phase-out limits, wants to diversify themselves from a tax-standpoint and has ran the numbers and feels that income or tax rates will be higher in the future and their potential for tax savings is greater down the road than it is now.

Non-Deductible Individual Retirement Account (IRA)

A Non-Deductible IRA is simply an IRA that you contribute to when you are phased out of your deductiblility.  Remember how we said that if you are covered by an employer plan and make too much money you can’t deduct your contributions? 

A Non-Deductible IRA is the result.

Last year I would never have given the non-deductible IRA a second thought.  It made very little sense to contribute to them. 

This year, however, it may make a lot of sense for folks.  Here’s why:

The income limits for Roth IRA conversions have been lifted, meaning anyone can convert money to a Roth IRA!

I won’t get into the details of this strategy here, since I talked about covnerting non-deductible IRA contributions at length in this post - but quickly, here is the strategy:

Make Non-Deductible IRA contributions (no tax write off); convert those contributions to a Roth IRA (no taxes owed); let your money grow tax-free in the Roth IRA (no taxes owed) and then pull out the money in retirement (no taxes due!)

Non-Deductible IRAs – The Right Retirement Account for You?

This strategy is right for those who make too much money to simply contribute to Roth IRAs, but still want to take advantage of tax diversification by getting money into a Roth.

Which Retirement Account is Right For You?

Readers, let’s hear from you – which is your favorite retirement account and why?

For some reason I get this question a lot, so I thought I’d provide a little clarification on IRA withdrawal rules.

Individual Retirement Arrangements or IRAs were designed to provide an opportunity for folks to save for retirement on a pre-tax, tax-deferred basis.  In other words, the money grows without having to pay any taxes on the gains.

Of course, with an IRA you have to pay the Piper at some point in time.  That means when you get into retirement and start your IRA withdrawals, you’ll have to pay taxes.  This can create a “tax-time bomb” in retirement, but I won’t get into that here.

The short answer to when you can take your IRA withdrawals is – any time! 

People are often shocked by that answer, but it’s true. 

You can access your money through an IRA withdrawal any time you’d like, but you just better be aware of the tax and penalty ramifications.

If you take your IRA withdrawal after age 59 1/2 you won’t have to worry about any penalties, just the taxes. 

There are some exceptions to taking money out before age 59 1/2, so let’s take a look at an early IRA withdrawal:

Your IRA Withdrawal Prior to Age 59 1/2

The general rule is that if you take an IRA withdrawal before 59 1/2 the IRS whacks you with a 10% penalty.  So, ideally you need to wait on your IRA withdrawal until you reach that age.

As with most IRS rules, there are some exceptions:

IRS publication 590 lists these exceptions to the 10% penalty for early IRA withdrawals:

• You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
• The distributions are not more than the cost of your medical insurance
• You are disabled.
• You are the beneficiary of a deceased IRA owner.
• You are receiving distributions in the form of an annuity.
• The distributions are not more than your qualified higher education expenses.
• You use the distributions to buy, build, or rebuild a frist home.
• The distribution is due to an IRS levy of the qualified plan.
• The distribution is a qualified reservist distribution

These exceptions to the early IRA withdrawal rules have some qualifiers on them so it’s important to look at the IRS publication to make sure you fit into one of these categories before you take the money out.

For example, the exception that says you can take the money in the form of annuity – basically what the IRS means here is that you must take “substantially equal period payments”  – in other words a set amount per year for either a) five years or b) til 59 1/2, whichever is longer.

Also, be aware that these exceptions are for the 10% premature distribution penalty NOT taxes!  You still have to pay taxes on any IRA withdrawal.

Your IRA Withdrawal After Age 59 1/2

Reaching the magic age of 59 1/2 is one retirement milestone you should look forward to.

Once you reach this age, you can begin to take your IRA withdrawal penalty free!  At this point you can take out as much as you want, whenever you want.

Again, there is no escaping the taxes (unless of course you open a Roth IRA) so just be aware that every dollar you pull out will be as if you earned that money for the year – it counts as ordinary income.

By the way, you literally must reach age 59 1/2 – not 59, 5 months and 15 days. You can take the money any time on the day you turn 59 1/2 or after.

Just because you turned 59 1/2 doesn’t mean you have to take the money out though.  You may not want to.  If you’ve done a good job establishing other sources of income, you may decide to wait.

Your IRA Withdrawal at Age 70 1/2

If you do decide to wait however, you won’t be able to leave that money in your IRA forever.

At age 70 1/2 you will be required to take a minimum distribution ( also known as RMD, which uses a formula set up by the IRS to determine the amount) and pay taxes on those withdrawals.

But, what if you don’t need the money and you’d rather wait?  That’s fine, but just know that good ol’ Uncle Sam will uppercut you with a 50% penalty on the amount that should’ve been distributed along with the normal taxes due.

They want to make sure they get their tax revenue some how. So be aware that sooner or later you HAVE to take money out of your IRA.

So remember, you can always take an IRA withdrawal, but you need to know the right rules and regulations to determine when a distribution will be right for you.

This was a post I originally did for ChristianPF.com and thought I’d share it here as well.

According to Wikipedia, Baby Boomers are those who are born between 1946-1964 – meaning they range in age from 46-64 years of age.

Retirement is certainly on their minds and they are concerned about how much they need for retirement savings.

As baby boomers approach the magical age, there are some pretty important things to keep in mind about saving for retirement.

Let’s take a look at five things to keep in mind about retirement savings:

Retirement Savings Is Up to You!

Ok, so this is no breakthrough – I’m not pretending to discover a cure for cancer by any means, but this point needs to be stressed over and over again.

Years ago, you could work for an employer for 30 or 40 years, retire with a nice pension provided by the company and collect your social security and be pretty comfortable in retirement.

Not anymore!  Companies are dumping their pensions left and right, Social Security will need a massive overhaul to avoid going defunct – so what does that mean for you?

You are on your own for retirement savings – and that’s OK.

When Can You Access Your Retirement Savings?

This is something that all baby boomers should get really familiar with.  Accessing your retirement savings is generally what’s going to provide you an income in retirement, unless you have other business income etc.

Most people recognize 59 1/2 as the magical age to access your retirement savings, but get familiar with the rules surrounding your withdrawals.  Here’s a couple of them to remember:

• You can access your IRA at any time, but be aware of the penalties.
• You can withdraw from your 401k savings prior to 59 1/2 without penalty if you are at least age 55 when you retire.
• You can take out Roth IRA contributions at any point in time, but the earnings must left alone until age 59 1/2.

What is Your Retirement Savings Number?

A few years back, Lee Eisenberg wrote a book called The Number, where he talks about what you’ll need for the rest of your life and what it will cost.  It’s an entertaining and informative look at what the rest of your life will look like.

You should be asking questions like, “Is a million dollars the magical number?”  Many people think they need much, much more than that, but is that right?

In light of this, you’ll need a good retirement calculator and you’ll want to sit down with your loved one and figure out your income versus expenses and determine how much retirement savings you need?

How Will You Diversify Your Retirement Income?

This is one that boomers probably have in the back of their minds, but some careful consideration should be done.

Will you have a pension, social security, 401k savings, IRA money, or annuities to help supplement your retirement income?

What about starting a business or turning a hobby into an opportunity to make some side money?  Have you considered other ways to make money and diversify your income in retirement?  You probably should.

Once again, retirement savings is up to you, therefore you need to be prepared and should have multiple lines in the water so that you’re not relying on the fish always biting from one particular source.

How Will You Diversify Your Retirement Savings From a Tax Standpoint?

Tax diversification is extremely important and is something that everyone should get familiar with and take a look at for their own situation.

In essence, tax diversification takes a look at the tax status of investing into three different vehicles.  You have tax-deferred, taxed-as-you-go (or non-qualified) and tax-free.

No one investment vehicle is right in every circumstance, but I think it’s very important to spread savings out among these three types of accounts because the greater the flexibility you have for accessing retirement savings, the greater the options you have for lowering your tax burden in retirement.  Plus, after reading why tax-deferral may not be all that it’s cracked up to be you might agree with me.

If taxes are high in some years, you have other money to withdraw from besides your 401k.  If tax rates are low, then why not pull money out of your IRA and consider a Roth conversion etc.

How About You?

Readers, what are some other things to consider for retirement?

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. 

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.