This is a guest post by Jeff Rose, a Certified Financial Planner. Rose is also the author of Good Financial Cents, a financial planning and investment blog. He’s also working on his book entitled Soldier of Finance, which combines his military background and financial planning experience.
Most Americans want to save for retirement, but most don’t know how to start. Putting money into a savings account is ideal for short-term goals and emergency funds, but there are better investment vehicles for long-term savings. One investment vehicle that I’ve grown to love almost as much as much as I love In-N-Out Burger (keyword: almost) is the Roth IRA.
I know Get Rich Slowly has covered the Roth IRA a lot in the past, but new readers might not be that familiar with it. Besides, even though you might think you know everything about Roth IRAs, here are some facts that might be new to you.
The Roth IRA has been around the block
Most people don’t know that the Roth IRA is getting close to getting its driving permit having been around for almost 14 years. It originally started with the Tax Relief Act of 1997, named after late Senator William Roth of Delaware. According to a study by the Investment Company Institute as of 2008, more than 15.9% of all U.S. households own a Roth IRA compared to 32.1% for Traditional IRAs.
There are more dollars invested in traditional IRAs, but look out: In 2004, contributions to Roth IRAs were $14.7 billion, while contributions to traditional IRAs were $12.6 billion. Many suspect that with the Roth IRA conversion event of 2010 it will lead to a further influx of Roth IRA contributions. Much can be attributed to this based on when the Roth IRA conversion was made available in 1998. During that time, 1.4 million taxpayers converted $39.3 billion in traditional IRAs to Roth IRAs.
Contributions to Roth IRA are not tax-deductible
Unlike other retirement vehicles, such as the employee-sponsored 401(k), contributions to a Roth IRA are not tax-deductible. Contributions to your Roth IRA are made with after-tax dollars, which does not offer an immediate tax benefit, but rather one that is recognized at the time of distribution. When you take a qualified distribution from your Roth IRA you will never pay taxes on that money.
This allows you to have access to your contributions at any time. That’s an attractive feature for those that want to save for retirement, but are worried about having to pay a penalty if they need access to the money.
While you don’t get a tax deduction, you may qualify for the Roth IRA savers credit. The downside of the credit is that if your income exceeds $27,500 filing single, or $55,500 married filing jointly, you don’t qualify.
You must meet eligibility requirements to contribute to a Roth IRA
As the Roth IRA gains in popularity among retirement savers, many people don’t realize that not everyone will be able to contribute to this type of account. In order to contribute to a Roth IRA, you must fall below the established income thresholds set forth by the IRS each year. The cutoff limits (otherwise known as phaseout limits) for 2011 are $122,000 for single filers and $179,000 married couples filing jointly.
If your income falls beneath the threshold for your filing status for the year, you must also make contributions from taxable compensation. This means individuals can not use rental property payments, royalties, or other non-taxable compensation to make contributions to a Roth IRA.
You may be able to convert other retirement accounts to a Roth IRA
Since 2010, there are new conversion rules that apply to the transferring of funds from a traditional IRA or 401(k) to a Roth IRA. When you convert from a tax-deferred retirement account to a tax-free retirement account, you’ll potentially see many benefits long term. It’s important to remember that the IRS isn’t going to forget about the taxation of this money. Whatever amount you transfer to the Roth IRA will be tacked on to your earned income (and taxed at your current rate) for the year of the conversion.
Please note: 2010 allowed you to split the tax bill over a multi-year period, but that expired in 2010.
The Roth IRA can be used for other savings goals
Usually experts recommend that retirement vehicles be used solely for retirement purposes. However, out of all the retirement accounts on the market, the Roth IRA can be used for other goals.
Since you’ve already paid taxes on your contributions, you’re able to enjoy tax-free distributions of those contributions (but not the earnings) before you reach retirement age. As long as all distribution requirements have been met, you may access that money for other things such as a down payment on a home or college tuition. Often times I’ll meet with young parents who are very ambitious about saving for the kids college but barely saving anything for their own retirement. In these situations, I’ll often suggest the Roth IRA as a viable substitute.
Roth IRA distributions don’t contribute to taxable earnings
One of the most attractive features of the Roth IRA is that when you start taking distributions, you don’t have to worry about them contributing to your taxable income. This is because Roth IRA contributions grow in your account tax free. This is because you are making contributions with after-tax dollars. With a traditional IRA, you make a contribution with pre-tax dollars, so you end up with a deduction. A traditional IRA contribution lowers your taxable income.
This is not the case with a Roth IRA. You get no tax benefit immediately for making a contribution to your Roth retirement account. You pay taxes on your income, and then you make your contribution. However, because you have already paid taxes on the money you use, you won’t be taxed on it again. Your money grows tax free. For those who think that they’ll be in a higher tax bracket or that tax rates will go up by the time they retire, this can be an advantage. You pay taxes at your current, lower rate, and then when you take your distributions, you avoid paying taxes at your future higher rate.
There’s a five-year rule for Roth IRA withdrawals
It’s possible to withdraw money that you’ve contributed to your Roth IRA at any time, tax- and penalty-free, as long as you meet the distribution requirements. However, if you want to withdraw the earnings from your Roth IRA, it’s important to realize that you must have the account for at least five years. The clock starts ticking from the first day of the tax year in which you designate your contribution. So, if you open your Roth IRA in September of 2011 and make your initial contribution, you can make withdrawals of your earnings starting 01 January 2016.
This also works if you open your Roth IRA before April 15th and designate the contribution for the previous year. For example, you can open a Roth IRA on 10 April 2012, and designate 2011 as the year for your contribution. Clock starts ticking on 01 January 2011, even though you opened your IRA in April.
The five-year rule also applies to conversions. You cannot withdraw the converted amount in your Roth IRA until five years have passed.
There are no required minimum distributions during the life of the Roth IRA owner
For some folks, required minimum distributions (RMDs) are a big problem with retirement accounts. This is a minimum amount that the IRS says you have to withdraw from your retirement account each year once you reach a certain age. With some accounts, like 401(k)s, this can be disheartening, since the RMD can add to taxable income, possibly putting you in a higher tax bracket.
However, with a Roth IRA, there are no RMDs. The owner never has to withdraw money if he or she doesn’t want to. It’s important to note that this privilege disappears upon the death of a Roth IRA owner; heirs to the Roth IRA must take RMDs (but the RMDs are still tax free). Inheriting a Roth IRA is very similar to receiving the proceeds of a paid out life insurance policy.
The Roth IRA is growing in popularity because it offers many benefits without several of the drawbacks associated with other retirement accounts. In addition to the information noted here, the Roth IRA allows for contributions for the remainder of your life, unlike the traditional IRA that restricts you from contributing after age 70-1/2.
A Roth IRA can be a great savings tool. Just make sure you understand Roth IRA rules that come with it, and be careful to adhere to them.