What is a Roth IRA?
The Roth IRA takes the traditional IRA or Individual Retirement Account and makes it the best option available for the under forty crowd. It adds a layer of flexibility that a 401(k) does not have allowing you to invest wherever you see the best opportunity. It is largely tax-free provided you follow a few simple guidelines. And if you start early, this could be the single best move you will ever make.
The late former Sen. William Roth (R-DE) co-authored the 1981 Kemp-Roth tax cuts. Included in that bill was the creation of Roth IRA. The bill allowed a person with an individual retirement account to invest their taxable income so that it could be withdrawn tax-free in retirement.
Traditional IRA vs. Roth IRA
When you compare the two types of IRAs side-by-side, the differences become apparent. A traditional IRA allows you to deduct the money you invest against the taxes you paid. A Roth IRA uses money that has already been taxed and, because of this, your contribution cannot be taxed again. The money contributed to the plan, called the principle, is yours to withdraw at anytime although I would strongly suggest against doing so.
The earnings in a Roth IRA grow tax-free as well. When the plan is available for distribution at 59 1/2, all of the earnings you have made on the contributions are tax-free. Not so with a traditional IRA. The earnings and the contributions are taxed at your current (retirement) rate when you begin distributions between age 59 1/2 and 70 1/2.
Some Caveats
The differences between the two types of IRAs do not stop there. In a Roth IRA, a qualified distribution can be made after five years. This non-taxable event allows you to withdraw up to $10,000 per person a couple can withdraw $20,000 for the purchase of a first home or to rebuild. You may also withdraw money to help a family member with their first home.
A Roth IRA can be an excellent way for young parents to save for their children's college. You may not even have kids at this age and if you do, thinking about college for them might lead you to make a bad choice: your retirement or your kid's college. Choose retirement.
In a Roth IRA, you can save money for your retirement. The money saved in a Roth IRA can be used for your child's college education. It is better to save the money for their education in a 529 plan or a Cloverdell but if those savings plans fall short and you do not want your child burdened with college loans, use can use some of the money in your Roth IRA to help offset those costs. Use his feature as a last resort. Keep in mind, you cannot borrow money for your retirement. Focus on your future first.
And although the contributions are yours and you can withdraw them, try not to. Keep that money working for you. But if you need the money, unlike a 401(k) loan, you do not need to pay it back nor will you be penalized. You will, however lose the earning potential that money had but it will not cost you otherwise. However, tap the earnings before 59 1/2 and you will be subject to all of the penalties a traditional IRA withdraw before that age. You will be taxed at your current income tax rate and pay a 10% penalty for the withdrawal.
Income Limits
Here are the 2012 Roth IRA Contribution Limits indexed by modified adjusted gross income and filing status. Depending on these factors, you'll either qualify for a full contribution, a partial contribution, or not be eligible to contribute to a Roth IRA for 2012.
Modified Adjusted Gross Income (MAGI) Eligibility Limits
Single, Head of Household, or Married Filing Separately*
| Modified AGI Between |
Contribution |
| $1 and $105,000 |
Full Contribution |
| $105,001 to $120,000 |
Partial Contribution |
| $120,001 and up |
Not Eligible |
* providing you did not live with your spouse during the year
Married Filing Jointly
| Modified AGI Between |
Contribution |
| $1 and $167,000 |
Full Contribution |
| $167,001 to $177,000 |
Partial Contribution |
| $177,001 and up |
Not Eligible |
Married Filing Separately
| Modified AGI Between |
Contribution |
| $1 and $10,000 |
Partial Contribution |
| $10,001 and up |
Not Eligible |
Contribution Limits
Your 2012 Roth IRA contribution limit is the smaller of your entire earned income or $5,000. This contribution limit applies to each person eligible so couples who are married filing jointly would qualify for $10,000 total contribution – $5,000 for each spouse’s IRA.
If you’re over age 50 you also qualify for a catch-up contribution in the amount of $1,000. This is in addition to your full contribution amount so the total maximum contribution limit for someone over 50 would be $6,000.
Determining Partial Contributions
The above values represent the full Roth IRA contribution. If you’re in the partial contribution range your maximum contribution amount is based on your modified adjusted gross income (MAGI) in comparison with your filing status and age.
| Contribution Limit = Maximum Contribution x |
(Upper Limit – MAGI) |
|
(Upper Limit – Lower Limit) |
Here are a few examples that should make this formula more clear:
Single Filer Under Age 50
| Contribution Limit = $5,000 x |
($120,000 – MAGI) |
|
$15,000 |
Single Filer Age 50 or Older
| Contribution Limit = $6,000 x |
($120,000 – MAGI) |
|
$15,000 |
Joint Filer Under Age 50
| Contribution Limit = $5,000 x |
($177,000 – MAGI) |
|
$10,000 |
Joint Filer Age 50 or Older
| Contribution Limit = $6,000 x |
($177,000 – MAGI) |
|
$10,000 |
Married Filing Separately Under Age 50
| Contribution Limit = $5,000 x |
($10,000 – MAGI) |
|
$10,000 |
Married Filing Separately Age 50 or Older
| Contribution Limit = $6,000 x |
($10,000 – MAGI) |
|
$10,000 |
Keep in mind, any money already contributed can stay where it is, you just cannot add to the account. This makes the Roth IRA even more important for younger investors to use and use now.
Counting the Differences
Lets do some basic comparisons. We will make the same contributions to both funds, assume annual compounding and regular investments on a monthly basis. We will also use the same $4,000 contribution limits ($4,000 divided by 12 = $333).
We will also assume you are twenty with a forty year horizon. The last assumption and the most unpredictable is inflation. With any luck, it will be at 3% when you retire. But that is only a guess.
| Roth IRAs vs a Taxable Account |
| Input |
0 balance | 0 balance |
| 8% savings | 8% savings |
| $333 | $333 |
| 40 years | 40 years |
| 0 tax rate (Fed) | 25% tax rate |
| 0 tax rate (state) | 6% tax rate |
| 3% inflation | 3% inflation |
| $489,269 | $270,829 |
If you have a company-sponsored plan that allows you to save money in a tax-deferred account, do it is well. Having a Roth IRA has no affect on that type of plan because the money you put in a Roth IRA has already been taxed. Use your company's plan in addition to your Roth IRA, especially if your employer offers some sort of a matching contribution.
Because this is best used for retirement accounts of younger investors, be more aggressive with the mutual funds you pick.
Opening an IRA is generally less expensive. Many mutual fund families lower the initial deposit for retirement savers. Many also allow you to make deposits online as well.
Some Quick Tips On Picking a Fund
- Look for a fund that has done better than its peers over a three to five year period. Avoid top ten lists of less time.
- Look for a fund manager that has been with the fund at least three to five years
- Look for a fund that has low expenses at least a third less than their peer group
- Look for lower turnover. This refers to the amount of times a portfolio changes in a given year. Turnover of 100% means the portfolio has changed once in a given year. A portfolio turnover ratio of 50% means the mutual fund has held on to its stocks for at least a year and half. A turnover ration of 150% means the manager is frequently selling the portfolio holding stocks less than six months.
- Look for no-load funds. Loads refer to the money you have to pay up front (front-loaded) or when you sell the fund (closed-end). A no-load fund puts the money you invest right to work.
