What is a Roth IRA and it’s Benefits?
First, what does IRA stand for? The answer, Individual Retirement Account. The Roth IRA has been described as “a tax gift” and it really does live up to this reputation. While the Roth IRA has only been around since 1997, it could be your gold mine when you retire.
All you need is to understand power of a Roth and to use the Roth during your working life. I am not saying this just for the Rich and Famous. The average working guy can have a very nice retirement, if he is eligible to use a Roth IRA and he uses it to save for his later years.
To understand the Roth IRA, start with the concept of IRA’s, why they were created, and some issues that had the general public complaining about the existing IRA rules.
The Original IRA Concept
The main idea behind all retirement plans is to push income taxes out until you retire. Otherwise, the contribution your company makes to your pension plan would be taxable to you this year instead of later on when you retire. Before 1974, if you didn’t have a pension plan, you had no way to save without paying taxes on interest every year. Simply not fair!
IRA’s hit the scene in 1974 for workers who had no pension plan. The concept was to allow these workers to contribute $2000 per year, deduct this from their tax return each year, and eventually pay taxes on interest when they retired. IRA’s became very popular. Workers saw their IRA accounts grow into nice nest eggs.
So what was the beef? Average workers making $60,000 (in today’s dollars) are in a pretty low tax bracket, meaning their tax rate is around 15% of pay. The tax rate for higher paid workers might be 25% or 30% of pay. So a tax deduction in 2011 of $5,000 saves the higher paid guy a lot more than the average worker. Yet the average worker gets hit with a pretty big tax bill when he retires and starts pulling out his money from the IRA.
Workers found that they still had to find a job after retirement, even with Social Security, to make ends meet. Essentially, the average guy still could not save enough to live on after tax.
Enter the Roth IRA. The Roth IRA was named after its Congressional sponsor, the late Senator William Roth of Delaware, and stated in 1997. He and his committee tried to find a way of letting workers have more after tax dollars when they retire, without having this cost the government a big loss in tax revenue currently. If his bill had caused a loss of tax revenue, the bill never would have passed Congress.
Roth’s idea was brilliant. Let worker put money into an IRA without getting a current tax deduction, but allow the entire account to be pulled out tax free when the worker retired.
The first reaction of the common investor was to ignore this new idea. They didn’t understand the long term benefits. Over the years, workers, especially Baby Boomers, have come to appreciate the power of the Roth IRA.
Roth IRA Rules
All the rules are explained in more detail in the other articles on this website. So here’s an overview:
Eligibility – anyone who earns money. A person who lives off his investments or pension cannot contribute to a Roth IRA
• If you are Married, Filing Jointly or a Widow(er), you can put in the maximum $5,000 if your income is under $169,000 per year. If you earn over $179,000 per year, you cannot contribute to a Roth. If you earn in between the two, you can contribute, but less than $5,000.
• If you are Single or Head of Household or Married Filing Separately, you can put in the maximum $5,000 if your income is less than $107,000 per year. If you earn over $122,000, you cannot contribute to a Roth. If you earn in between the two, you can contribute but less than $5,000.
• Regardless of filing status, if you are age 50 or over, you can put in an extra $1,000 each year, for a total of $6,000.
The Power of a Roth IRA -Advantages
1. After age 59 ½, all withdrawals of your contributions and any earnings are totally tax free – yes, tax free so enjoy your retirement. This point alone should pop your eyes if you can look out toward your retirement.
2. If you need to take out money before age 59 ½, you can pull out the contributions you made without any penalty since they were already taxed before you put them in. Great for an emergency fund.
3. If you haven’t owned a home in the last 2 years, you can withdraw up to $10,000 and put it toward buying a new home without penalty. Not a big deal but it helps.
4. You can contribute to a Roth IRA if make contributions to other retirement plans such as the 401k, 403b or qualified education savings plan. This is a huge advantage. You can’t do this in a Traditional IRA since the IRS doesn’t want you deducting contributions to both an IRA and 401k plan.
5. If you die and your spouse becomes the sole beneficiary, he or she can combine the two separate Roth IRA accounts without any tax penalties. You probably don’t care about this one but your spouse will.
6. If you expect your tax bracket go up after you retire, you definitely want to contribute to an IRA now. This can easily happen if you plan to work after your retire, collect Social Security, and take withdrawals from your IRAs.The advantage of Roth is paying the tax now and not worry about having to pay taxes later.
7. All other retirement plans force you to take minimum withdrawals, since the IRS wants to finally get their taxes. The Roth has no minimum withdrawal rules. Take the money whenever you want (after 59 ½) and forget about the IRS.
Disadvantages of a Roth IRA
1. The main downside of a Roth IRA is that your contributions are NOT tax deductible so you will have to pay taxes on them. Then again, a tax deduction now for the average worker doesn’t mean much unless you are in higher tax brackets.
2. Eligibility for Roth IRA contributions is stricter than the Traditional IRA. Maybe, but many workers qualify for both.
3. Some workers may not live to retirement, so the tax advantages may never be realized. You have to live until your total Roth IRA contributions are withdrawn after retirement to realize the full benefits of a Roth, which includes living well into the 70s. Also, with a Traditional IRA, the IRS may never collect tax from you if you die before retirement. This is true and needs some thought, but you would be no worse off than if you had simply put your money into a savings account all along.
Which is Better Roth IRA or Traditional IRA?
Do you love the benefits of a Roth, but don’t want to lose the tax deduction you get from a Traditional? Then, diversify plans.
Put some money in a Roth and the rest in a Traditional. Or ever better, put all your money in a Roth during your early years when you earnings are low, and then put money in a Traditional in the later working years when your earnings are higher (putting you in higher tax bracket).
I said at the start that the Roth IRA is a “tax gift”. Too many workers, especially young ones, can’t bring themselves to look out toward retirement and what their financial situation will be at that time. Understandable, since most of us are just trying to survive a bad economy, low wage increases, inflation, etc. You don’t have to put in the maximum amounts allowed. The important point is to Just Get Going and open a Roth IRA now.
Put in what you can afford – $50, $100, or $200 per month. You will be amazed at how it grows over the years. Put it this way, if you contribute $200 per month, earning 4% interest, in 25 years this will grow to $ 103,313.57 which you can take out Tax Free. Can you really afford NOT to open a Roth IRA?