Why I love the Roth IRA

Want tax-free investment growth? Want more control over your retirement savings? Want to leave a bigger inheritance? If so, you should consider contributing to or converting existing retirement savings to a Roth IRA.

For Not-Yet-Retirees

The biggest difference between a Roth IRA and a traditional IRA is the tax treatment of contributions and withdrawals. With the Roth, contributions aren't tax-deductible, but withdrawals are tax-free (as long as you follow the rules). For the traditional IRA, contributions might be deductible; investments grow tax-deferred, but withdrawals are taxed as ordinary income — the highest rate possible.

To decide which is best for you, start by determining if you'll be able to deduct contributions to a traditional IRA. If you're not covered by a plan at work, a contribution to a traditional IRA is fully deductible. If you are covered, then deductibility begins to phase out at an adjusted gross income (AGI) of $55,000 for single filers ($89,000 for married couples) and is gone completely at an AGI of $65,000 ($109,000). Contributing to the Roth is then a no-brainer, assuming you're eligible (see fact sheet below).

If you can deduct your contribution to the traditional IRA, you'll have to do some calculations to decide whether a traditional IRA or Roth makes the most sense. The conventional wisdom is that a traditional IRA is better if your tax bracket today is higher than what it will be in retirement. But if you're more than 10 years away from retirement, this is a guessing game. Go with a Roth for all the other benefits.

Another bonus for younger savers: Contributions to a Roth IRA can be withdrawn anytime tax- and penalty-free, even if you haven't reached age 59-1/2 (but you will pay a 10% penalty on earnings you withdraw early). So if you'll need the money before then, you can get it. Finally, there are two other important differences between a traditional and Roth IRA: There no required minimum distributions at age 70-1/2 from a Roth IRA, and you can contribute beyond that age as long as you have earned income.

For Retirees

Since there are no required minimum distributions from a Roth, you can let your investments grow tax-free for as long as you don't need the money. And unlike distributions from a traditional IRA, non-taxable distributions from a Roth IRA aren't included in the calculation that determines whether your Social Security benefits will be taxed, which might mean double the tax savings.

For Heirs

The tax treatment of IRAs is the same for owners and beneficiaries. Anyone who inherits a traditional IRA will have to pay ordinary income taxes on the distributions. Not so with the Roth. The account will still maintain its tax-free status. And nothing says “I love you” like giving someone tax-free retirement savings. (Keep in mind that all accounts, IRAs or otherwise, are subject to estate tax if the combined value of a decedent's assets exceeds the exclusion amount, which is $3.5 million in 2009.)

Roth IRA Fast Facts

Who can contribute? Anyone with earned income. Eligibility begins to phase out for single taxpayers with an adjusted gross income above $105,000 and married taxpayers above $166,000.

How much can I contribute in 2009? $5,000 (plus another $1,000 if you're age 50 or older).

Are contributions tax-deductible? No.

How are withdrawals taxed? They're tax-free, as long as you're age 59-1/2 or older and the account has been open at least five years.

Must I take money out at age 70-1/2? No.

Why is it called a “Roth”? Named after Delaware Sen. William Roth Jr. (also known for leading investigations into Pentagon overspending that uncovered the infamous $9,600 wrench and $640 toilet seat).

Why is it so good for colds? You're thinking of “broth.”

Should You Convert to a Roth IRA?

A traditional IRA can be converted into a Roth IRA by anyone whose modified adjusted gross income is below $100,000. The converted amount will count as taxable ordinary income in the year of the conversion (unless the IRA contained non-deductible contributions). But for many people, that one-year tax bite is worth the subsequent years of tax-free growth.

Here are the factors to consider:

  • Generally, convert only if you can pay the taxes from sources other than the converted funds, especially if you're younger than 59-1/2 and will have to pay a 10% penalty on the money you withdrew to pay the taxes.
  • If you're near retirement and you expect to be in a much lower tax bracket, the conversion probably won't be worthwhile. This is also true if the conversion will push you into a higher bracket than where you'll be when you take money out of the Roth.
  • If you're in a lower tax bracket now but required minimum distributions at age 70-1/2 will push you into a higher bracket, converting portions of your traditional IRA to a Roth over a few years (partial conversions are okay) might smooth out your taxes.
  • If you expect to pay estate taxes, a conversion will save your heirs money because the taxes you pay today will reduce your estate, and assets in a Roth for your heirs will be subject to estate taxes, but not income taxes.

Want some help crunching the numbers? Fiddle around with the calculators on The Motley Fool retirement page.

For more information on the wonders of the Roth, check out the Get Rich Slowly series on Roth IRAs: What is a Roth IRA and why should you care?, How to start a Roth IRA (and where to do it), Which investments are best for a Roth IRA, and Questions and answers about Roth IRAs.

More about...Retirement, Investing

Become A Money Boss And Join 15,000 Others

Subscribe to the GRS Insider (FREE) and we’ll give you a copy of the Money Boss Manifesto (also FREE)

Yes! Sign up and get your free gift
Become A Money Boss And Join 15,000 Others
guest
49 Comments
Oldest
Newest Most Voted
Inline Feedbacks
View all comments
J.D.
J.D.
11 years ago

I have no idea how I managed to get comments turned off on this post. Sorry. They’re on now! 🙂

ICU
ICU
11 years ago

This article answers clearly every question I’ve had, and failed to get answered clearly, about the difference between traditional and Roth IRAs. Great stuff and thanks.

Sam
Sam
11 years ago

Another point, in 2010 (assuming the rules don’t change) you will be able to convert certain IRAs to Roth IRAs as the income limits will be lifted (you may or may not have to pay taxes to do so, depends on whether you took a deduction on the IRA). Also, if you make to much to contribute to a Roth IRA you may want to see if your employer has a Roth 401K option (mine does) as the rules and benefits are similar and the contribution limits are higher ($16,500) per year. I split my 401k monies between regular and… Read more »

IndependentOperator
IndependentOperator
11 years ago

What about the risk that legislation is passed at some point in the next 20-40 years of your life that cancels the tax exemption on earnings in an effort to raise revenue to fund the $53+ trillion in promised future Medicaid and SS benefits that have no current funding source?

Omer
Omer
11 years ago

I hear this all the time, you should contribute to a Roth IRA, Roth IRA is a no-brainer, blah blah….. I think we all should know that contributing to this is smart but only if you make less than $166,000. So what do the people who make more that $166k do?

Blogging Banks
Blogging Banks
11 years ago

Another important fact is that if you are switching between jobs, you could transfer your 401K to a ROTH IRA, which could benefit you tremendously. First you put pre-tax dollars into a 401K, and then you are taking out money from a roth IRA as tax free income.

Chris
Chris
11 years ago

One thing that he didn’t mention is that if you withdraw money to buy your first home, you won’t get charged the 10% penalty:

“First home. Even if you are under age 59½, you do not have to pay the 10% additional tax on up to $10,000 of distributions you receive to buy, build, or rebuild a first home.”

Kevin M
Kevin M
11 years ago

Blogging Banks is completely wrong. You CANNOT transfer a 401(k) directly into a Roth and take it out tax free. You would roll the 401(k) into a traditional IRA, then convert it to a Roth – which is a taxable event.

Also, the blog fails to mention that some traditional IRA contributions COULD be tax free on distribution, due to the possibility of original nondeductible contributions. All this should be tracked on Form 8606.

Sdub
Sdub
11 years ago

You ought to publish an article on this important loophole… there are effectively NO income limits this year on Roth IRAs. In 2010 ONLY, anyone (regardless of income) can roll over a traditional IRA to a Roth IRA, a special provision of the 2006 TIPRA act (part of the original Bush stimulus package). I’m not eligible for Roth’s anymore, based on income, but I’ve been funding traditional IRAs since 2006 waiting for this one-time “special offer” from Uncle Sam. All I pay is tax on investment growth from 2006 until today… and let’s just say that’s not going to be… Read more »

Kevin M
Kevin M
11 years ago

@Orner – if you’re an employee, there isn’t much you can do except max your 401(k)/403(b) or whatever. Also, tell them you want a Roth option if you don’t have it already.

If you’re self-employed there are myriad choices over and above IRAs – most of which allow you to contribute much more than $5k annually.

DCH
DCH
11 years ago

What a superb breakdown of the intricacies of the Roth IRA! I didn’t know about the fact that Roth distributions don’t count toward making SS taxable income and good to learn about the inheritance tax benefits too. Most discussions on Roth IRAs omit (or even worse, contradict) the option for Roth contributions (not earnings) to be withdrawn penalty-free. After all, you’ve already been taxed on it once, right? Excellent article!

Kevin M
Kevin M
11 years ago

@Sdub – You’ll pay tax on the entire amount converted to a Roth, UNLESS you’re contributions were all originally nondeductible.

Josh
Josh
11 years ago

Q: I have about 3K in my rollover with Vanguard, and about 8K in my Vanguard Roth. I’m 24 and starting my new gov’t job next week. Should I convert my 3K rollover IRA to Roth? I assume I’ll be in lower tax bracket by being so young, but what do you all think? Help.

ttirremr
ttirremr
11 years ago

Another example of our government’s bias against people who make money. See the “Fast Facts” in the article. If you make much over $100K ($80K each if married) you aren’t eligible. You are not considered “working people” and it’s morally wrong for you to try to accumulate any savings. You should be ashamed. So your government should punish you. Time for a flat tax and regime change.

Jacob
Jacob
11 years ago

Here’s my question: When I go to my bank and say “I want to open an IRA”, and they say “Ok where do you want your money to go”, I have no idea what that means. If I understand correctly, I can turn any “account” into an “IRA”, right? So I could turn a regular savings account into an IRA, a CD into an IRA, or an investment account into an IRA. Is that correct? What’s the best way to manage an IRA? Right now, my company has pretty good 401k management options (completely passive, “target retirement” portfolios, or completely… Read more »

rma
rma
11 years ago

If you want to convert from a traditional IRA to a Roth IRA, do you have to convert all at once? Or could you reduce your tax bill by converting incrementally, say $5K-$10K per year?

Mark
Mark
11 years ago

For what scenarios does it make sense to convert a traditional IRA into a Roth IRA? Most of us are under on our retirement accounts now so does that make it a good time?

Craig
Craig
11 years ago

I recently opened up a Roth IRA account for retirement and set up automatic transfers each month. Getting started early is better and everyone seems to be praising them these days.

J.D.
J.D.
11 years ago

Folks, some — but not all — of your questions can be answered by following the links to my past Roth IRA series of posts.

Kevin M
Kevin M
11 years ago

@Jacob (#15) – there are certain limits to property you can hold in an IRA, but your examples would be fine. If you have a CD or investment account already established, you’ll just have to open an IRA account and have them transfer in the assets. Watch the annual contribution limits though, depending on how much $ is there.

@rma (#16) – you do not have to convert everything at once. If your account is $10k and you want to do 25% each year for 4 years that is fine, or half over 2 years.

IndependentOperator
IndependentOperator
11 years ago

@Jacob, I suspect there are a lot of people out there that have the same reaction. First, I will say: don’t get into the trap of hearing that an IRA is a good thing and then deciding you need one. If you don’t know why you need one, then you don’t need one. It’s your choice whether you want to invest (no pun intended) the time to understand IRAs and then make the appropriate investments or if you’d rather just stay out of it altogether (sounds like you’re doing the former, and I would too!). What is not advisable and… Read more »

Andy
Andy
11 years ago

Hey Jacob, I just opened up a roth ira w/ my bank so I know exactly what you’re talking about. The deal is that you have to pick something to ‘buy’ with your money. You can get straight notes or whatever, in which case your account would not grow and would remain worth the same forever, depreciating in value for tomorrow’s dollar because of inflation. You can buy ETFs, bonds, whatever. I personally chose to buy stocks. I’ve ‘purhcased’ $1,000 bucks worth of the QQQQ (and my next move will be to ‘purchase’ some DIA). The Q’s and DIA are… Read more »

J
J
11 years ago

@Jacob I would suggest opening a Roth IRA online through a low cost mutual fund such as Vanguard (where I have mine) or Fidelity, etc. I can only speak to Vanguard, but I assume the others are equally simple – you just have to create an online account, choose a fund (I chose a target retirement for simplicity, but they do have many others ranging from super conservative to higher risk), and transfer your funds in. Usually if you agree to automatic recurring transfers (again what I did in order to dollar cost average) there is no minimum (or a… Read more »

E
E
11 years ago

ttirremr – If you make over $100k you are clearly smarter than the rest of us and don’t need government help. Kind of like I made straight A’s in high school without the dollar-each incentive my brother got to bring his grades up. Not fair, but that’s life. 😉 Thanks for the ongoing articles about Roth IRA’s; this one is particularly clear and helpful. I need to get off my butt and open one. I’m not willing to convert my current IRA’s since I don’t want to pay the tax on them all at once and I’ve no idea what… Read more »

fern
fern
11 years ago

OK, here’s a question that’s always nagged at me. I may have accidentally mixed in a non-deductible traditional IRa contribution into an account that had all tax-deductible contributions.

My question is, how would the IRS determine I screwed up andpossiblly owed some money? Would it be in the 1 or 2 years following the time you did that, or would they somehow figure it out when i started the withdrawals down the road?

V. Higgins
V. Higgins
11 years ago

I have a slightly involved question. I’m 23 and have a company matching (7%) 401(k) that I’m contributing to. It’s with Fidelity, is a Roth possible? Should I stick with the 401(k) since it’s being company matched?

Adam
Adam
11 years ago

Can you convert the other way (from Roth to Traditional)?

I don’t really know which to choose…I’m just below the income requirements for Roth, but I don’t know if that will be the case a year or two from now…

arabella
arabella
11 years ago

What about Roth IRA vs. 401k? I am already putting the matchable amount, and now I can’t decide if I should increase my 401k (yay pre-tax savings!) or open a Roth IRA. I have savings-savings, so I don’t think I’ll need to take the money out of the Roth IRA. What else do I need to consider to make this decision? thanks!

arabella
arabella
11 years ago

What about Roth IRA vs. 401k? I am already putting the matchable amount, and now I can’t decide if I should increase my 401k (yay pre-tax savings!) or open a Roth IRA. I have savings-savings, so I don’t think I’ll need to take the money out of the Roth IRA. What else do I need to consider to make this decision? thanks!
P.S. – Sorry, forgot to tell you great post!

IndependentOperator
IndependentOperator
11 years ago

@arabella,

The general advice is to do the following in order until you don’t have any more money to save:
1) contribute to 401k until employer stops matching
2) max out Roth IRA contribution ($5k this year)
3) max out 401k ($16.5k this year)
4) contribute to normal taxable investment account

The last will incur a lot of transaction costs, so you probably don’t want to be doing dollar cost averaging…

Snowballer
Snowballer
11 years ago

“What about the risk that legislation is passed at some point in the next 20-40 years of your life that cancels the tax exemption on earnings in an effort to raise revenue to fund the $53+ trillion in promised future Medicaid and SS benefits that have no current funding source?” Well there’s a risk of something similar with any financial product, as all financial products are really just legal constructs. There’s been lots of proposals the last few years to remove the tax benefits of 401ks but they haven’t gone anywhere. I do see this kind of possibility as more… Read more »

Kevin M
Kevin M
11 years ago

@fern (#25) – you can mix nondeductible and deductible contributions in a traditional IRA. However, it’s your responsibility to track you basis (nondeductible contributions) and figure out the portion that is taxable upon withdrawal. Form 8606 does this for you. If you haven’t been filling that out, start doing so.

To go back and find your nondeductible contributions, compare all your 1040s to your Form 5498s. Form 5498 reports all IRA contributions, so if you take that total, less what was deducted on your 1040 – you should get your nondeductible amount.

Paul in cAshburn
Paul in cAshburn
11 years ago

@Independent Operator #4: “What about the risk that legislation is passed at some point in the next 20-40 years of your life that cancels the tax exemption on (Roth) earnings…?” Understood, but what about the opportunity that Roth accounts provide in the event that regular tax rates go up to 50% to pay for the Congress’ and Presidents’ deficit spending, but they DON’T cancel the tax exemption on Roth withdrawals. Roth conversions would be even more valuable under that scenario. Which is more likely? My crystal ball is on the blink… so I’ll diversify and have both Roth and non-Roth… Read more »

Paul in cAshburn
Paul in cAshburn
11 years ago

@fern #25: “OK, here’s a question that’s always nagged at me. I may have accidentally mixed in a non-deductible traditional IRa contribution into an account that had all tax-deductible contributions. My question is, how would the IRS determine I screwed up and possiblly owed some money? Would it be in the 1 or 2 years following the time I did that, or would they somehow figure it out when I started the withdrawals down the road?” Putting money into an IRA is putting money into an IRA. You’re not putting deductible or non-deductible money in. Whether your deposit into the… Read more »

Zyzzyx
Zyzzyx
11 years ago

@IndependentOperator (#30)

I’ve seen that general progression before, and makes good sense to me. But what if your employer also has a Roth 401k plan as well, where would that fit in the sequence?

Currently I’ve got an employer match of 6%, and I’m putting 13% each in Trad 401k and Roth 401k. Its time to change it up.

Sheila
Sheila
11 years ago

Under who can contribute, non-working spouses weren’t mentioned (at least I didn’t see it). From what I understand, a non-working spouse can contribute to his/her own Roth IRA if the other spouse received earned income. If that’s not true, then I’ve been doing something wrong for a number of years now.

Kevin M
Kevin M
11 years ago

@Sheila – you’re understanding is correct. You just have to watch what is contributed in total doesn’t exceed your spouse’s earned income.

IndependentOperator
IndependentOperator
11 years ago

@Zyzzyx: Good question. It actually does not change the progression. Whether and how much you go with the Roth option on your 401k is an independent decision, although I would imagine it would be influenced on whether you are maxing out your Roth IRA. The only thing to keep in mind is that employer matches are, as far as I know, always deposited into your 401k as traditional contributions (pre-tax). 1) contribute to 401k until employer stops matching 2) max out Roth IRA contribution ($5k this year) 3) max out 401k ($16.5k this year) 4) contribute to normal taxable investment… Read more »

Archna Jagtiani
Archna Jagtiani
11 years ago

The article is really good.
I love ROTH IRA a lot. I have one. It is a IRA so the money is protected from bankruptcy. Also, you can withdraw in emergency the amount put in after 5 years.
The greatest advantage is that it is tax free growth.

Ed
Ed
11 years ago

This has already been touched on above and let me preface this by saying I max out mine and my wife’s IRA’s yearly (waiting for the 2010 conversion). But with the current and past ‘Govmint’ spending that is going on, not only will tax rates increase, but other ways to tax Roth’s will come into effect. One would be a ‘national sales tax’ if that ever came into play then all the Roth monies that are supposed to be tax free will now be taxed as you spend it. Another could be a means test for future Social Security benefits.… Read more »

DCH
DCH
11 years ago

@Ed (2:57 pm) I agree that the future might not be kind to us as savers. We can’t expect the same rules to apply in 20-30 years (for me) upon retirement. However, if changes such as the ones you described ever come to pass, then all the more reason to save as much as possible now (even in a Roth IRA) to offset such effects! I’m not going to avoid investing (in a Roth) to protect myself from the possibility that some of it might be taken away later. Not only Roth distributions, but all sources of retirement income will… Read more »

kick_push
kick_push
11 years ago

my problem is knowing WHEN to contribute to a roth.. i have the 5k at hand for 2009.. i just don’t know if i should put it in now (or later)

i started in 2006

thefamilynomics
thefamilynomics
11 years ago

Hey, Kick
If I were you and had 5K to put for roth. I would put one third now. So atleast some money is working for me right away. Also, I would wait for a pull back to put the rest.

kick_push
kick_push
11 years ago

thefamilynomics.. sounds like a good idea.. i was thinking $2500 now and the other half at the end of the year

Oblio
Oblio
11 years ago

Great article, but I have a few questions.

1. When I convert from a Traditional IRA to a Roth IRA will I have to pay taxes on just the basis (my yearly contributions)or will I be taxed on the basis and the earnings?

2. When I choose to convert (before 2010) is the full value of the Traditional IRA I’m converting added into the calculation of my modified adjusted gross income. In other words, can the value of the Traditional IRA I’m converting put me over the $100,000 eligibility limit?

3. Lastly, are my Roth IRA yearly earnings taxed?

Annie
Annie
11 years ago

Oblio,

For (3), the answer is no — that’s the entire tax advantage of a Roth IRA. You pay income tax, then you contribute to the Roth IRA, and then that money isn’t taxed again — not while it earns interest and not when you take distributions after retirement.

Petunia
Petunia
11 years ago

Oblio #1 – When you convert, you pay ordinary income tax on every dollar converted, irrespective of if it is a dollar you contributed or a dollar of growth.

Oblio #2 – No, the value of your conversion does not put you over the 100k limit. According to IRS publication 590, your “modified AGI for Roth IRA purposes” is your AGI as shown on your return and then modified. One of the listed modifications is subtracting Roth IRA conversions. There are other additions and subtractions, so please refer to publication 590 available at irs.gov.

Petunia
Petunia
11 years ago

I contribute to both Roth and traditional. I opened the Roth only last year, so it is small. If you intend to use withdrawals from your traditional as a source of income (as I do), then you need to consider what you will do if say, you need 20k for a new roof. If you withdraw 20k + income taxes from your traditional for that purpose, then you have just permanently reduced your future annual withdrawals, or you have just permanently reduced the probability that you will not run out of money in your lifetime. I expect to have enough… Read more »

Britt (Your Roth IRA)
Britt (Your Roth IRA)
11 years ago

Excellent article. There are many reasons to love the Roth IRA. And while I’ve seen it addressed in the comments, I didn’t see it thoroughly addressed in the original article… The significance of the 2010 Roth IRA conversion rule change and its impact can not be overstated. While the Roth IRA income limits remain in effect for new 2010 contributions, the IRS eliminates the income limit on Roth IRA conversions, and that’s essentially the same thing as eliminating the income restrictions on making a Roth IRA contribution. Why? Because if you make too much to contribute to a Roth, you… Read more »

shares