What is a Roth IRA? and Why You Need To Own One
By CHM on Jul 16, 2007 in Financial Planning, Retirement, and Now!, Roth IRA Rules, Traditional IRA
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I have made a lot of references so far to the mighty Roth IRA. I’ve stated before that the advent of the Roth IRA is one of the most beneficial pieces of legislation to ever come out of Washington D.C.
In my mind, Uncle Sam has given the American public a gift here, its time to take that ball and run with it, especially those of you in your 30’s and 40’s.
Because of the importance of the Roth IRA I plan on covering it thoroughly here… probably over the course of many many many posts. Lets start with the basics…
What is a Roth IRA?
A Roth IRA is an Individual Retirement Account that differs from a traditional IRA in that the contributions you make to your Roth IRA are never deductible on your income tax return, at the same time, qualified distributions are INCOME TAX FREE.
So here’s what you’re faced with in the future… you have the choice of having a deductible regular IRA and paying a lot of taxes in the future or having a non-deductible Roth IRA and paying NO TAXES. Hmmm…. which IRA should you have? IMHO… ROTH, ROTH, ROTH!
(In this blog I will also refer to a traditional IRA as a regular IRA… they are the same thing).
The maximum annual contribution to a Roth IRA is the lesser of $4000 or earned income. Basically, you need to have earned income of at least $4000 a year to be able to make the maximum $4000 contribution for 2007. If you are age 50 or more, you may make an additional $1000 contribution making the max contribution $5000 for 2007.
It’s Ok to have both a traditional IRA and a Roth IRA; many people have traditional IRA’s from way before the Roth IRA ever came in to effect. The only caveat, the amount you contribute to a Roth IRA each year must be reduced by any contribution to a regular IRA… making the maximum contribution between the two IRA’s for 2007… $4000 total.
Income restrictions
Currently there are income restrictions on who is qualified to make a Roth IRA contribution and who can not. If you are single taxpayer whose AGI (adjusted gross income) is more than $114,000 in 2007, you can’t make a Roth contribution. If you are married filing jointly and your AGI is more than $166,000 in 2007, you can’t make a Roth contribution.
Now that last paragraph may be a bit of a buzzkill for those of you who don’t qualify but things aren’t all bad; #1- you’re earning a pretty nice wage #2- don’t lose hope because there are big changes rollin’ round the bend.
Regardless of how much income you make you can always make a regular IRA contribution, although it may not always be deductible. This is a very important point because it introduces a backdoor way for those who can’t normally make Roth contributions into having a flourishing Roth IRA in the not so distant future.
I will get back to that and explain ‘the big changes rollin’ round the bend’ in full detail in an upcoming post…
Tags: Roth IRA Contribution Limits, Roth IRA Rules, Traditional IRA, What is a Roth IRA
Dan | Feb 4, 2008 | Reply
Ciaran,
The Tax Free Myth of the Roth IRA is pretty widespread. In fact, it is just tax pre-payment. With a Traditional IRA or 401K, you pay taxes later, with a Roth, you pay them now. The net effect is the same, isolating income tax from other factors such as changing tax rates and taxation of social security benefits. There are still reasons the Roth is beneficial to those eligible, but I just think they shouldn’t have the misconception that they are paying less tax.
Dan
CHM | Feb 4, 2008 | Reply
Good points Dan… but no one ever isolates changing tax rates and taxation of social security when having this discussion and how can you, the uncertainty of those for me is one of the deal clinchers in favor of the Roth.
I don’t think there is any misconception they are paying less tax, if you’re converting to a Roth IRA then an awful lot of preparation must go into making sure the necessary fund are available.
But there’s no denying that the difference in potential future growth (over 30 years or more in some cases) is what makes the Roth so much more powerful than a traditional, again if utilized properly.
Thanks for commenting I appreciate your feedback.
Dan | Feb 4, 2008 | Reply
I disagree with your final point about the difference in potential future growth. The potential for future growth is the same.
Let’s say I’m in the 25% tax bracket now. If I contribute $100 per month to a Traditional IRA and average a 10% APY, I will have $226,048 in my IRA in 30 years. If I remain in the 25% tax bracket, that is the equivalent of $169,536 (can’t all be drawn in one year). Now, the Roth:
If I choose the Roth, I will pay $25 in taxes now and invest $75 per month. Earning 10%, that will grow to $169,536. Voila!
If I can keep myself in the 15% tax bracket in retirement, the traditional IRA or 401(K) is the better choice for me. For those currently in the 15% bracket, it will be a wash. If they end up in the 25% bracket in retirement, the Roth would be better. To manage this tax-rate risk, I recommend investing in both deductible plans and Roth IRAs.
CHM | Feb 5, 2008 | Reply
Dan,
Your opinion represents the status quo and that’s fine.
If you re-read what I wrote I said, ‘over 30 years or more’. Factor in not having to take RMD’s or taking distributions at all, using it as an estate planning tool. The potential for growth is far greater than a traditional IRA because you are not forced to hemorrhage taxable monies at 70 1/2.
If you want to read more about how I really feel go here… http://chancefavors.com/2008/01/purpose-of-roth-ira-vs-traditional-ira/
Be sure to play the video.
Dan | Feb 5, 2008 | Reply
From my point of view, your opinion reflects the status quo. Almost everywhere I turn, I hear someone jumping up and down about how the Roth IRA is tax free. My point is that it’s not. It’s tax neutral. The benefits of the Roth are the RMD and taxation of social security benefits.
I’ve made a comment on your other article. Too many financial professionals run comparisons like yours. Comparing $5,000 in a Roth versus $5,000 in a traditional is a no-brainer. Not because of the Roth’s benefits, but rather because by investing $5,000 after tax, you are investing more. It’s not an apples to apples comparison.
By the way, I like the Roth. I own one and have roughly half of my retirement assets in it.
CHM | Feb 5, 2008 | Reply
We will agree to disagree on some points. At some point I’ll write a more comprehensive article.