Roth IRA:  What Is It?

A Roth Individual Retirement Account (Roth IRA) is named after the late Delaware Senator, William V. Roth.  Senator Roth was its chief legislative sponsor.  Let’s take a look at the workings of a traditional IRA, a Roth IRA and a Roth 401(k).

Some of the advantages of the Roth IRA are as follows:

• You can withdraw your contributions at any time tax-free and with no penalty. 
• Maximum annual contributions are $5,000.
• Savings grow tax-free for the lifetime of the Roth IRA, and are not taxed when withdrawn after the age of 59-1/2.
• You can invest your Roth IRA in stocks, mutual funds, CDs, bonds or real estate.
• You can withdraw up to $10,000 of the earnings tax-free, including interest, and without penalty, to purchase your first home – cannot have owned a home in the previous 24 months.  The only other caveat is that the account has to have been opened for 5 years in order to pay no penalty for the interest withdrawn. 
• If your Roth IRA is open less than 5 years, you’ll only have to pay taxes on your interest, no penalties will be imposed if you withdraw interest to pay for a home.  
• A spouse, as sole beneficiary, upon the death of a Roth IRA owner, does not pay penalties to combine an existing Roth IRA with the one inherited.  This only applies if another Roth IRA is owned by the spouse.

Some of the disadvantages of the Roth IRA are as follows:

• Withdraw the interest early – before the age of 59-1/2 – and you’ll alert a tax bill on it, along with a 10% penalty.
• You cannot withdraw rollover contributions until the account has been open for 5 years.
• You must have earned income from your job.
• You can only contribute as much as you make each year. 
• Contributions are not tax deductible.
• You must make less than $101k for a single person and $159k for married filing jointly in order to contribute the full amount.
• Contributions do not diminish your gross taxable income, since they are not deducted from your pre-tax dollars.

Traditional and Roth IRAs are both smart tax shelters

Money you put into either a traditional or Roth Individual Retirement Account (IRA) is sheltered from taxes. Income from interest, dividends and capital gains in an IRA will compound each year without taxation. Furthermore, depending upon whether you choose a traditional or Roth IRA, you can avoid paying tax on either the money you put into the plan initially or on the money you withdraw for retirement.

There’s a difference when you withdraw

You are not required to withdraw funds from a Roth IRA – the money you have there can stay and grow until you decide to take it out. A traditional IRA, on the other hand, requires that you start taking minimum distributions at age 70-1/2. When you withdraw any amount of money from a traditional IRA, you must pay taxes at your present income tax rate. When you withdraw money from a Roth, you pay no tax.

Is going with a Roth a no-brainer?

That last point about paying no tax could lead you to believe that deciding in favor of a Roth is a no-brainer. But you must take one fine point into consideration: Money you put into a Roth IRA is money you will have paid taxes on already. In contrast, money you put into a traditional IRA is pre-tax money. The end result is subject to debate.

Video: Traditional IRA or Roth IRA?

Maximum contributions and  income limitations

Generally speaking, if you will be under 50 years old at the end of 2009, the maximum annual contribution you can make to either a traditional or Roth IRA is $5,000; if you will be 50 years old or older before 2010, the maximum contribution you can make to either a traditional or Roth IRA is $6,000.

Income caps do not apply to traditional IRA contributions. However, if your income exceeds specific amounts, you can’t contribute to a Roth. It’s wise to talk to a tax advisor or the Internal Revenue Service (IRS) to find out how your income level can affect the maximum amount you may contribute to a Roth IRA.

Early-distribution penalties

Money withdrawn from a traditional IRA before you reach age 59-1/2 will be subject to a penalty fee of 10% of accrued earnings (with some exceptions). Money withdrawn from a Roth IRA is free of penalty if you:

• Take the distribution no earlier than five years after you start your IRA.
• Reach age 59-1/2.
• Are disabled.
• Die and your beneficiary takes the distribution.
• Purchase a first home.

Tax implications for retirement

When planning for retirement, think about your future tax rate. If your tax rate during retirement will not be lower than your present rate (which may seem unlikely), a Roth IRA could be the best option. If your tax rate during retirement will be lower then it is now, a traditional IRA could be best. You may want to consider dividing your contributions between the two types of IRAs. Talk to your financial advisor about the difference in maintenance fees that may be charged by your IRA trustee if you have just one IRA vs. more than one.

Moving money around

You can put almost anything in either type of IRA account: stocks, mutual funds, bank Certificates of Deposit – from high-risk to government insured. And you can transfer money from an eligible retirement plan – a 401(k) or pension, for example -- into an IRA and from one IRA to another without fear of penalty or taxation if you do so within 60 days. In certain circumstances (natural disasters, for instance), you may be able to obtain a waiver of this 60-day rollover requirement.

Converting from traditional to Roth

Video: Secret of Roth IRA Conversion

If your financial situation changes (or you find a new advisor) you may be tempted to convert your IRA from a traditional plan to a Roth. If you do convert, you will have to pay taxes on the withdrawal from your traditional IRA, but you won’t have to pay an early-withdrawal penalty. Is this a good idea? That depends on your income tax rate today compared with what you imagine it could be after you retire. You may find that you’d be giving up too much in taxes to make the conversion worth the trouble.

Roth 401(k)

A Roth 401(k) is a cross between a Roth IRA and a traditional 401(k).  It is an option allowed under your employer’s traditional 401(k) plan.  You cannot enroll in a Roth 401(k) without investing in a traditional 401(k) plan.

Here is some more information about a Roth 401(k):

• You invest in a Roth 401(k) like you invest in a traditional 401(k) – through an employee deduction plan.
• You invest after-tax income, but pay no taxes when taken out.
• Maximum annual contribution is the same as a traditional 401(k) – $15,500.
• Roth 401(k) contributions are irrevocable.  You cannot reassign the contribution to a traditional 401(k) later.
• No company contributions can be made to your Roth 401(k).
• You make designations annually, they are not perpetual.
• Retirement funds from another account cannot be rolled over into a Roth 401(k).  They will have to be direct deposited. 
• You won’t be able to take any contributions out from a rollover IRA to pay for a first home until they are invested in the account for 5 more years.

How to Invest in a Roth IRA

You’re informed and ready to invest.  There are many different resources you can use to do this.  You may already have investments with an investment company.  If so, contact the company in which you invest for specifics. 

Get an opinion, and a second opinion.  Some money gurus say taxation rules make a Roth the better choice; others say it’s pretty much a wash between the two types of plans. Find a financial advisor who’s got an opinion one way or the other; then get a second opinion. There are some other important ways in which choosing between the two types of IRAs requires decision making on your part.

Otherwise, the web has an abundance of investment sites available for investing in a Roth IRA.  Do a search on investments and you’ll come up with a thorough selection of investment companies to choose from.

In regards to investing in a Roth 401(k), contact your employer’s benefits group for more information.

More information from the Internal Revenue Service

What is a traditional IRA?

More about traditional IRAs

Information about Roth IRAs

Taxes and Roth IRAs

IRA contribution and deduction limits 

Payroll deductions for IRAs

Advice for business owners

Options for small businesses

Options for military personnel