Roth IRA! Roth IRA! Roth IRA! I am sure you have never heard that pep rally cheer at any program you have gone to. But then again, most times we suggest that we need to look at your goals and objectives and a bunch of other aspects of your life before we make recommendations on what you should do with your money.
For this blog I am assuming most readers would say “I need to put money away for my eventual retirement and I have a few goals along the way that will require some money to be saved. I just don’t know when those goals will show up or how much they will cost me.” Those elusive goals might include a down payment on a house or tuition for your children’s education.
So the important thing here is you need to save money, you want access to this money when these goals show up, and you want this to be tax efficient along the way. In the end, the money not used on other goals will be funding your retirement.
Given the above requirements, I would be recommending that you have the Roth IRA on your list of places to be putting your money each year. So let’s look at what the Roth IRA is all about.
The Roth IRA was established by the Taxpayer Relief Act of 1997 (Public Law 105-34) and named for its chief legislative sponsor, Senator William Roth of Delaware. In the first year (1998) of this program, the annual limit was $2,000 that could be contributed to this retirement fund for you (and your spouse if married) based on the level of your earned income. As long as you earned at least the maximum allowed to be contributed, you could have a Roth IRA. So if you earned $1,500 in a year, you were limited to contributing $1,500 to the Roth IRA.
Contributions to a Roth IRA are from after-tax income which is where it gets some of its tax-free benefits. In addition, contributions to a Roth IRA are over and above what you might be contributing to a 401k or 403b type program through your employer.
Today the annual contribution limit for 2011 and 2012 is $5,000 per year if you are age 49 and below and $6,000 per year if you are age 50 in that year. This limit assumes that you had at least that amount in earned income for the year. If you are married, the earned income for both of you would have to be twice those amounts. There are limitations to contributing to a Roth IRA based on your income, but there is a way around that limitation (a subject for another time).
When you contribute to a Roth IRA, the earnings on the Roth IRA grow tax-deferred just like the earnings in your employer’s 401k plan during the period of accumulation while you are working and saving. Once you reach age 59 ½, the total value of the Roth IRA (contributions and earnings) is available for withdrawal by you with no income tax liability for any amount withdrawn. That is a huge difference and advantage over your 401k account which will be totally taxable as you make withdrawals each year. That means you have increased purchasing power with the Roth IRA money compared with the 401k money.
The second advantage of the Roth IRA account is that during the years before you reach age 59 ½, you have access to the amounts you contributed each year with no tax consequences. This is because you would be withdrawing what you had contributed annually form after tax dollars. What you cannot touch during this period is the earnings portion of your account – that amount would be subject to a penalty if withdrawn before age 59 ½.
A third advantage becomes available to you at age 70 ½ and later. The Roth IRA does not require any minimum annual distributions like you are required to do with your 401k account that you may have rolled over to an IRA when you left your employer or retired. If you do take money from the Roth IRA in your later years, the amounts withdrawn do not create any taxable income under current laws.
A fourth advantage becomes available to your heirs upon your passing. The heirs get to receive this money in annual or lump sum distributions in the same tax-free way that you would have. By contrast, if they receive your 401k/IRA as an inheritance, they will have to pay taxes on the amount withdrawn each year, just like you did.
The fifth advantage is tied to those other goals that you might have along the way. Let’s use the college tuition as the example. Your child reaches college age and you need some money for tuition. You could withdraw the amount from the Roth IRA for the tuition as long as it was less than the annual contributions you had made to date. For instance, if you had contributed $5,000 per year for 15 years you would have a total of $75,000 that could be withdrawn from the Roth IRA to meet the college expenses. There would be no tax liability on that withdrawal and the remaining value of that account would continue to grow for your retirement.
Had you decided to take money from your 401k/IRA to pay the same $75,000 of college expenses, you would have had to pay income tax and probably a 10% penalty for that early withdrawal.
All these advantages are not without some penalty to you. The biggest disadvantage is that you are putting this money into the Roth IRA with after-tax money. This means you already paid tax on the amount your contributed each year as compared to the amount you put into the employer 401k plan was before taxes. That tax cost to you would be based on what your incremental tax rate is currently applied to the contributed amount. If you are in the 15% tax bracket, then the tax cost on the $5,000 contribution is $750 on your annual contribution.
In the meantime, the growth of your Roth IRA investment over many years did not cost you any income taxes!
Roth IRA! Roth IRA!
Francis St. Onge, CFP®
Total Financial Planning, LLC