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- In addition to the hallmark difference, direct contributions to a Roth IRA can be withdrawn tax free anytime you want.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 Your earnings can be withdrawn tax and penalty free if you meet certain conditions, such as being over 59.5.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:
|Year||Age 49 & Under||Age 50 & Over|
|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.
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.