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Roth IRA Account Explained

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This Foundation post is dedicated to what I consider the best retirement weapon available – the Roth IRA account. The Roth IRA was championed by Senator William Roth of Delaware and created with the Taxpayer Relief Act of 1997, signed by President Clinton. The primary tax benefit of the Roth IRA, at least the one most lauded, is that your account’s appreciation and earnings are tax free. The tradeoff is in the contributions, which are not tax-deductible.

This is the biggest distinction between it and the Traditional IRA. On a traditional IRA, your contributions are tax-deductible but your earnings and appreciation are taxed as ordinary income when you start making regular disbursements in retirement.

Other Tax Advantages

  • In addition to the hallmark difference, direct contributions to a Roth IRA can be withdrawn tax free anytime you want. Since you’ve already paid taxes on the money, the logic is you should be able to access it if you want. Your earnings can be withdrawn tax and penalty free if you meet certain conditions, such as being over 59.5.
  • You can contribute to a Roth IRA regardless of your other retirement options. With a Traditional IRA, your contributions, or their tax treatment, are restricted based on your employer’s retirement options. With the Roth IRA, your employer’s options are irrelevant.
  • $10,000 Withdrawal Rules: You can withdraw up to $10,000 of earnings tax-free if it is used to buy your primary residence and you are a first time homebuyer. To be a first time homebuyer you cannot have owned a home in 24 months.
  • No required age-based distributions: With other retirement accounts, there are required minimum distributions based on your age. The Roth IRA has no such requirement.
  • This Wikipedia article has a good comparison of all retirement accounts, worth looking at if you’re deciding where you want to contribute.

There are several other tax benefits but those are the headline ones.

Roth IRA Contribution Limits

The Roth IRA account is so nice, the government puts a contribution limit on it. There is a standard limit followed by a “catch-up” limit for those aged 50 and over:

Contribution Limits

Year Age 49 & Under Age 50 & Over
2008 $5,000 $6,000
2009 $5,000 $6,000
2010 Indexed to inflation Indexed to inflation

Starting in 2010, the contribution limit will be adjusted in $500 increments in line with inflation.

In addition to the contribution limit, there is an income eligibility phase-out too. If you are single and have a modified adjusted gross income (MAGI) between $105,000 and $120,000, then your contribution is reduced by how much you earn. If you earn more than $120,000, you cannot contribute to a Roth IRA. For married filing jointly, the phaseout runs from $166,000 to $176,000.

The phase-out is reduced by the percentage you exceed the floor of the phase-out. For single filers, if you earn $110,000, then you are $5,000 above the floor and can only contribute 66% of the contribution limit, rounded up to an even $10 increment – $3,300. If that contribution limit is ever below $200 but above $0, then you can contribute $200.

Risks

The Roth IRA account is not without risk. The idea of it sounds perfect, I pay taxes now, I let it grow, and I get all my money back tax free. How more perfect can it be? There are actually one big risk with the Roth IRA: Tax rates could go down. In theory, a Roth IRA and a Traditional IRA perform the same if you assume the same rate of return and the same tax bracket structure when you withdraw the funds in retirement. The risk is that taxes could go down.

Don’t think it could happen? If the United States were to ever go to a consumption tax system, such as the VAT in Europe, then you might see income taxes go down as sales taxes go up. If that were to happen, then your Roth IRA would be taxed twice. Once when you made the contribution and then again when you went to spend the money in retirement. Before you think that will never happen, remember that retirement may be decades away for you… a lot can happen until then.

2010 Roth IRA Conversion Loophole

Right now (2009), you cannot rollover a traditional IRA or rollover IRA into a Roth IRA if your income exceeds $100,000. In 2010, that restriction is lifted (it’s known as the 2010 Roth IRA Conversion Limit Loophole). This allows two things:

  • If you’ve wanted to convert a Traditional IRA into a Roth IRA, now is your chance. You simply have to pay taxes on the amount you’re converting from a Traditional to a Roth IRA. It is best to pay the tax with non-retirement funds.
  • If you want to contribute to a Roth IRA but can’t because of income restrictions, you can contribute to a non-deductible Traditional IRA and then immediately convert it into a Roth. This is possible because the income limit has been lifted.

Reader Julio reminds us, in the comments, that the taxes you have to pay on the rollover amount can be spread out across two years so you don’t have to pay the entire bill at once. For more details, contact a tax professional because they would know the exact procedure for taking advantage of the loophole.

Where to open an account?

The answer is anywhere. If you want to invest in mutual funds, I recommend going directly to the mutual fund company. If you like Fidelity funds, go with an account at Fidelity. If you like Vanguard funds, go with an account there.

If you want to buy stocks, my recommendation is that you go with a discount broker. You want to spend as little as possible on trades and keep the funds in your retirement account so they can continue to grow.

Finally, with the current income restrictions, there might come a day when you can’t contribute to a Roth IRA account (this happens for a lot of people when two young professionals get married). When that day comes, you might regret not taking advantage of it for all those years.

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26 Responses to “Roth IRA Account Explained”

  1. Nice analysis.

    The Roth is a very good tool for many people . . . the nice part is the money has already been taxed at known tax rates as opposed to unknown future tax rates . . .

  2. Julio says:

    Great Post on the Roth IRA. I don’t think I’ve come across the ‘Risks’ that you mention here in any of the research I’ve done on the Roth IRA, and it does give you something else to think about. You may also want to mention the 2010 conversion rule, were taxes due on conversions beyond 2010 can be spread over two years. So the 2010 conversion amount may be included as taxable income in 2011 and 2012.

  3. Great post! I think you explained the Roth IRA pretty well!

    I would not really consider the tax risk right now. Considering the present situation (high level of debt), changing the taxation system sounds like gambling.

    Since someone will have to pay for all those Trillions spent, my bet would be to see US tax rate going up, don’t you think?

  4. I covered some Roth/traditional scenarios a while ago:

    http://www.observingcasually.com/roth-vs-401k/

    Among the scenarios that could come into play – your current income is considerably higher than your projected retirement income (you get a crazy bonus from work), making the traditional a better option (because you avoid taxes at the higher rate today instead of avoiding them at the lower rate in the future). On the flip side, people with lower income than their projected retirement income (such as recent college graduates) are much better off with Roth.

    If the rates are exactly the same, it is a wash (although other factors can affect things a bit). Having the tax bite taken up front completely offsets the fact that the appreciation is not taxed.

    A quick example: assume money will triple between now and retirement and that tax rate is 50%. (Yes, I realize you can’t dump in 100k – this is for illustration purposes)

    Roth:
    Start with $100,000
    Pay taxes of $50,000
    Invest remaining $50,000
    $150,000 at retirement

    Traditional
    Start with $100,000
    Invest entire $100,000
    Have $300,000 at retirement
    Pay taxes of $150,000 at retirement
    End up with $150,000

    • Julio says:

      An argument can also be made for taxes being higher at retirement. At retirement we won’t have deductions for children or child care, and ‘hopefully’ we won’t have deductions for our mortgage interest. Add to that the fact that historically taxes do tend to go UP, and so do our incomes over the years, putting us in higher tax brackets later in life. So paying taxes on Roth IRA contributions *today* seems like the way to go, rather than paying taxes on IRA contributions decades from now at retirement.

      • Yes, I touch on these issues in my article.

        While tax rates do go up (and sometimes down), the breakpoints are also adjusted for inflation. So a higher income 50 years from now might not necessarily be taxed at a higher rate – because it might be a bracket or two below where it is currently

  5. Matthew says:

    I believe it is incorrect that “a Roth IRA and a Traditional IRA perform the same if you assume the same rate of return and the same tax bracket structure when you withdraw the funds in retirement.” For one thing, you are allowed to put $5000 of after-tax money into the Roth IRA whereas you put $5000 of pre-tax money into the Traditional IRA. It seems to me that this means you can effectively put more money into the Roth IRA.

    • JC says:

      perhaps looking at the account in isolation you are correct (eg. $5000 that grows tax-free and $5000 that grows only to get taxed, the former is obviously going to have more), but we do not live with IRAs in isolation. If you go the Trad IRA route, you have extra money in the now and present that you can use (or invest in taxable account) because it did not go to the taxman. in the end, all else being equal, it is a wash.

      • Matthew says:

        You make a good point. I’m still not entirely convinced that it’s a wash though, especially if you invest the money in a taxable account. The extra money you’ll have to invest in that account from using a traditional IRA will be subject to the drag of taxes for all those years so it seems like you will end up with a lot less if your gains are significant (which I would assume they will be over 30 or more years) relative to the Roth IRA. I’ll have to sit down and look at a specific example when I have more time.

    • freeby50 says:

      Matthew, the assumption is that with a traditional IRA you’d be putting away more than the $5000 of after tax money. You’d put an equivalent pre-tax amount into the traditional IRA.

      Say you make $50k a year and the tax rate is 20%. You could put $6250 into a traditional IRA or you could pay $1250 in taxes and put $5000 into a Roth IRA. So with the traditional IRA you put more in the account to begin with since you got it tax free.

  6. Neil says:

    The second big risk with Roth-type accounts is regulatory risk. With a traditional IRA you receive your tax benefit today. With the Roth, you are counting on the rules being the same in a few decades when you want to retire. It is not outside the realm of possibility that withdrawals may be taxed at some point in the future.

    Also, I think the income limits and 2010 loophole are probably overplayed. If you’re a high income earner, would you want to pay taxes today on your entire contribution (at the highest marginal rate), or pay as you withdraw when portions of the withdrawal will be taxed at lower rates…even if you do retire to the same tax bracket, which most people won’t.

  7. Bankrate.com has a good 401(k) vs. Roth IRA calculator at http://www.bankrate.com/calculators/retirement/401-k-or-roth-ira-calculator.aspx?pid=p:brg

    Roth IRA seems to be a better plan for me assuming current conditions.

    Good risk analysis! But as much as I love Huckabee’s plan to tax consumption vs. income, I doubt that’s going to happen. But just incase, I’ll contribute to both 401k and Roth.

  8. TJ Shah says:

    I have a Traditional IRA account with Mainstay. I want to bring it over to Vanguard or Fidelity. Is it advisable to do so and what should I watch out for?

  9. AJ says:

    Great post. I am about to get one with fidelity.

  10. Great post! I’m so happy I FINALLY set up my Roth IRA last week.

  11. I would add a couple of things.

    1) ROTH IRA as emergency fund – Since you have already paid taxes on your contributions, you can withdraw your principal without penalty or taxes on it. You have to wait a certain number of years on roll overs but it makes a great way to combine an emergency fund with retirement savings.

    2) Roth 401ks now exist which allow you to place more money into them that traditional IRAs so ask your employer about them.

    3) The best way to balance the known and unknown issue – use both a Roth and Trad 401k. That way you are prepared for whatever happens and can save more for your retirement. You can also use a trad and Roth IRA but won’t get the benefit of higher savings amount.

  12. eric says:

    I love the Roth IRA…they better not mess with it!

  13. Patrick says:

    Roth IRAs are great. I always get asked that same question, where to put the money. It seems to be a common misconception with IRAs that you have to put it into a particular organization or a bank.

    • Jeff Rose says:

      Haha! It’s so funny you say that because Jim and I were just discussing that. I’ve had numerous discussions with folks that just don’t get.

      Recently, a guy asked me what our Roth IRA rates are. I tried to explain the difference and he just responded with, “Well, I know my banks is paying 2% so what’s yours paying?” I tried to explain again to no avail. Here’s a quick story on it…..

      http://www.goodfinancialcents.com/best-roth-ira-rates/

  14. Dan says:

    “Tax rates could go down.”

    LMAO.

  15. Ryan says:

    One factor I have only heard mentioned once is that the tax you save today in a traditional IRA is at your marginal tax rate (ie, the highest tax percentage you would pay on any of your income) while the tax you save on a Roth would be at a various brackets (ie the first x dollars withdrawn would be taxed 10%, the next x dollars at 15% etc…). So in effect even if you are in the 25% bracket now and at retirement only in the traditional will you be actually seeing the tax benefit on that 25%.

  16. Javier says:

    I’ve read a few articles about IRAs but this is the first article that helped me understand the difference between trad. and roth. Thanks!


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