Resources: Financial Planning: Roth IRA – Is it the Best IRA for You?

Roth IRA — Is it the Best IRA for You?

The Roth IRA was designed to encourage more Americans to save for retirement. For many people, it offers significant tax advantages over traditional IRAs. The trick is in determining if you fall into this category of taxpayers. Along with potential tax savings, the Roth IRA comes with a set of complex rules which can make it difficult to determine if the Roth IRA is your best IRA investment option.

Eligibility requirements and contribution limits

Regular contributions to all IRAs combined may not exceed annual limits as follows:

$3000 for tax years 2002–2004

$4000 for tax years 2005–2007

$5000 for tax years 2008 and thereafter

The full amount may be contributed to a Roth IRA by:

single taxpayers with an Adjusted Gross Income (AGI) of up to $95,000 or
married taxpayers that file a joint return with an AGI of up to $150,000.

A reduced contribution may be made by:

single taxpayers with an AGI of $95,000 to $110,000;
married taxpayers who file jointly with an AGI of $150,000 to $160,000; or
married taxpayers who file separately and earn from $0 to $10,000.

No contributions are allowed for taxpayers with AGI beyond these levels. Income limits apply regardless of participation in an employer-sponsored pension plan.

Conversion contributions to a Roth IRA are allowed for all individuals beginning in 2010. Married couples that file separate returns are not eligible to convert traditional IRAs to Roth IRAs.

Taxpayers who turn 50 in a given year are allowed to make ‘catch-up contributions’ to their Roth IRA. These amounts are in addition to the regular contribution limits above. For 2002 through 2005, $500 more per a year can be placed in a Roth IRA. For 2006 and later years, the catch-up contribution is $1000.

Advantages of a Roth IRA

The key difference between the traditional IRA and the Roth IRA involves the timing of taxes. Money invested in a traditional IRA is tax-deferred. Eligible contributions are made with pre-tax dollars, decreasing the amount of taxable gross income. However, taxes are paid when distributions are taken from the account. Therefore, both contributions and earnings are taxed as money is withdrawn. Conversely, contributions to a Roth IRA fund are made from net income. Qualifying distributions are tax exempt: neither contributions nor earnings are subject to taxes.

In order to qualify for the tax exemption, distributions from a Roth account may not occur until five years after the account is established. One of the following four criteria must also be met: The account owner must reach the age of 59 ½; or withdraw money for first time homebuyer expenses; or withdraw funds due to disability; or the withdrawal must occur after the owner’s death. Only early withdrawal of earnings, not contributions, is subject to taxes and penalties.

Because of the compounding of interest and tax-free accumulation of funds, money placed in a Roth IRA for 5 years will produce more after tax income than the same amount invested in a traditional IRA. This makes the Roth IRA particularly appealing to younger investors.

Since money can be withdrawn from a Roth IRA tax-free after age 59 ½, it offers an excellent college-savings plan for middle aged parents. The yearly contribution is more than is allowed with an Coverdell Education Savings Account and is not counted in college aid formulas.

The Roth IRA also offers options for estate planning. The minimum distribution rule which applies to traditional IRAs requires that the owner start taking distributions by April 1st of the calendar year following the year he reaches age 70 ½. This rule does not apply to Roth IRAs, allowing an individual with other retirement income to leave the fund intact to accumulate tax-free. An individual can also continue to make contributions to the Roth IRA after age 70 ½.

Individuals who participate in employee sponsored retirement plans are allowed a tax-deductible contribution to a traditional IRA within certain income guidelines. The option of making a tax deductible contribution to a traditional IRA phases out for single employees earning $55,000 – 65,000 annually and couples with a combined annual income of $89,000 – 109,000 (as of 2009). Beyond these limits, traditional IRA contributions are nondeductible. The Roth IRA’s expanded allowable income range encourages retirement planning by more people. Participation in an employer-sponsored retirement plan, including a pension plan, profit- sharing plan or 401K, does not affect Roth IRA contributions. Furthermore, savings in a SEP, SIMPLE, or Education IRA do not preclude investment in a Roth IRA. Investors who would be eligible only for a non-deductible IRA contribution should consider a Roth IRA instead. In both cases, the contribution is not deductible, but the Roth IRA offers greater flexibility and the potential for tax-free earnings.

Converting a Traditional IRA to a Roth IRA

As a general rule, conversion of a traditional IRA to a Roth IRA makes sense for most people who are 5 years or more from retirement. Money can be transferred from one IRA to another without incurring early withdrawal penalties as long as the transfer is completed within 60 days. Starting in 2010, there is no longer an income limitation for who can do a Roth IRA conversion. This maneuver is to your advantage if you can pay the taxes on the traditional IRA distribution from another source, for two reasons. First, money withheld from the rollover to pay taxes on the distribution would be subject to the early withdrawal penalty. Second, the value of the fund is in effect increased when other assets are used to pay taxes (the gross-up effect).

When You Should Not Open a Roth IRA

Despite its many appealing features, there are investors whose circumstances make the traditional IRA the better alternative to a Roth IRA. Like all investment decisions, it must be made on an individual basis. Key areas to consider are eligibility requirements, contribution amounts, and plans for distributions. To help you make your decision, consider the following scenarios where the traditional IRA would be more appropriate than the Roth IRA, and weigh your options carefully.

Your first distribution will occur less than five years after establishing the fund.

Distribution of earnings must be made more than five years after the Roth IRA was established. A withdrawal of earnings before the end of the five-year period is subject to taxes (always) and penalties (with a few exceptions). If you are less than five years from retirement, the traditional IRA is the appropriate choice to avoid early withdrawal penalties.

You plan to begin taking distributions from your fund before age 59 ½ (with the exception of qualified first time homebuyer expenses).

To be non-taxable, distributions from a Roth IRA must be made on or after the date an individual becomes 59 ½, OR paid to a beneficiary or an estate after an individual dies, OR made due to the owner’s disability, OR for qualified first time homebuyer’s expenses. If these criteria weren’t met, the regular IRA might be the better investment.

You expect your tax bracket to decrease significantly when you retire.

If you expect that your tax bracket will be at least 10 points lower when you retire than when you make contributions, the regular IRA offers the advantage of a current tax deduction. Taxes paid on distributions at a later date will be made at the lower tax rate, creating a larger after tax accumulation.

You are not financially able to make the full allowed contribution.

A smaller investment in a Roth IRA will not realize as large a benefit from compounding interest and tax-free accumulation. The up-front tax deduction offered by the traditional IRA may be financially advantageous. Consider this scenario carefully, however. What are your future investment plans?

You are rolling money over from a traditional IRA to a Roth IRA and you don’t have money to pay the taxes on the IRA distribution or you are married but filing a separate return.

Funds can be rolled over from a traditional IRA to a Roth IRA, and will not count toward adjusted gross income if the transfer is completed within 60 days.

Important note: This is a summary and, as such, it is not intended as a complete explanation of all applicable situations. Many exceptions, definitions, and special rules in the law have been paraphrased, simplified and/or omitted. Readers should not take specific action in reliance on this summary without consulting the statute and regulations or seeking advice from a qualified professional.

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Overview Business Financial Planning Elective Deferrals Your Financial Paperwork First Time Homebuyer and IRA Withdrawals Funding Health Care Expenses Planning for College Roth IRA – Is it the Best IRA for You? Individual QuickBooks Other		Roth IRA — Is it the Best IRA for You? The Roth IRA was designed to encourage more Americans to save for retirement. For many people, it offers significant tax advantages over traditional IRAs. The trick is in determining if you fall into this category of taxpayers. Along with potential tax savings, the Roth IRA comes with a set of complex rules which can make it difficult to determine if the Roth IRA is your best IRA investment option. Eligibility requirements and contribution limits Regular contributions to all IRAs combined may not exceed annual limits as follows: $3000 for tax years 2002–2004 $4000 for tax years 2005–2007 $5000 for tax years 2008 and thereafter The full amount may be contributed to a Roth IRA by: single taxpayers with an Adjusted Gross Income (AGI) of up to $95,000 or married taxpayers that file a joint return with an AGI of up to $150,000. A reduced contribution may be made by: single taxpayers with an AGI of $95,000 to $110,000; married taxpayers who file jointly with an AGI of $150,000 to $160,000; or married taxpayers who file separately and earn from $0 to $10,000. No contributions are allowed for taxpayers with AGI beyond these levels. Income limits apply regardless of participation in an employer-sponsored pension plan. Conversion contributions to a Roth IRA are allowed for all individuals beginning in 2010. Married couples that file separate returns are not eligible to convert traditional IRAs to Roth IRAs. Taxpayers who turn 50 in a given year are allowed to make ‘catch-up contributions’ to their Roth IRA. These amounts are in addition to the regular contribution limits above. For 2002 through 2005, $500 more per a year can be placed in a Roth IRA. For 2006 and later years, the catch-up contribution is $1000. Advantages of a Roth IRA The key difference between the traditional IRA and the Roth IRA involves the timing of taxes. Money invested in a traditional IRA is tax-deferred. Eligible contributions are made with pre-tax dollars, decreasing the amount of taxable gross income. However, taxes are paid when distributions are taken from the account. Therefore, both contributions and earnings are taxed as money is withdrawn. Conversely, contributions to a Roth IRA fund are made from net income. Qualifying distributions are tax exempt: neither contributions nor earnings are subject to taxes. In order to qualify for the tax exemption, distributions from a Roth account may not occur until five years after the account is established. One of the following four criteria must also be met: The account owner must reach the age of 59 ½; or withdraw money for first time homebuyer expenses; or withdraw funds due to disability; or the withdrawal must occur after the owner’s death. Only early withdrawal of earnings, not contributions, is subject to taxes and penalties. Because of the compounding of interest and tax-free accumulation of funds, money placed in a Roth IRA for 5 years will produce more after tax income than the same amount invested in a traditional IRA. This makes the Roth IRA particularly appealing to younger investors. Since money can be withdrawn from a Roth IRA tax-free after age 59 ½, it offers an excellent college-savings plan for middle aged parents. The yearly contribution is more than is allowed with an Coverdell Education Savings Account and is not counted in college aid formulas. The Roth IRA also offers options for estate planning. The minimum distribution rule which applies to traditional IRAs requires that the owner start taking distributions by April 1st of the calendar year following the year he reaches age 70 ½. This rule does not apply to Roth IRAs, allowing an individual with other retirement income to leave the fund intact to accumulate tax-free. An individual can also continue to make contributions to the Roth IRA after age 70 ½. Individuals who participate in employee sponsored retirement plans are allowed a tax-deductible contribution to a traditional IRA within certain income guidelines. The option of making a tax deductible contribution to a traditional IRA phases out for single employees earning $55,000 – 65,000 annually and couples with a combined annual income of $89,000 – 109,000 (as of 2009). Beyond these limits, traditional IRA contributions are nondeductible. The Roth IRA’s expanded allowable income range encourages retirement planning by more people. Participation in an employer-sponsored retirement plan, including a pension plan, profit- sharing plan or 401K, does not affect Roth IRA contributions. Furthermore, savings in a SEP, SIMPLE, or Education IRA do not preclude investment in a Roth IRA. Investors who would be eligible only for a non-deductible IRA contribution should consider a Roth IRA instead. In both cases, the contribution is not deductible, but the Roth IRA offers greater flexibility and the potential for tax-free earnings. Converting a Traditional IRA to a Roth IRA As a general rule, conversion of a traditional IRA to a Roth IRA makes sense for most people who are 5 years or more from retirement. Money can be transferred from one IRA to another without incurring early withdrawal penalties as long as the transfer is completed within 60 days. Starting in 2010, there is no longer an income limitation for who can do a Roth IRA conversion. This maneuver is to your advantage if you can pay the taxes on the traditional IRA distribution from another source, for two reasons. First, money withheld from the rollover to pay taxes on the distribution would be subject to the early withdrawal penalty. Second, the value of the fund is in effect increased when other assets are used to pay taxes (the gross-up effect). When You Should Not Open a Roth IRA Despite its many appealing features, there are investors whose circumstances make the traditional IRA the better alternative to a Roth IRA. Like all investment decisions, it must be made on an individual basis. Key areas to consider are eligibility requirements, contribution amounts, and plans for distributions. To help you make your decision, consider the following scenarios where the traditional IRA would be more appropriate than the Roth IRA, and weigh your options carefully. Your first distribution will occur less than five years after establishing the fund. Distribution of earnings must be made more than five years after the Roth IRA was established. A withdrawal of earnings before the end of the five-year period is subject to taxes (always) and penalties (with a few exceptions). If you are less than five years from retirement, the traditional IRA is the appropriate choice to avoid early withdrawal penalties. You plan to begin taking distributions from your fund before age 59 ½ (with the exception of qualified first time homebuyer expenses). To be non-taxable, distributions from a Roth IRA must be made on or after the date an individual becomes 59 ½, OR paid to a beneficiary or an estate after an individual dies, OR made due to the owner’s disability, OR for qualified first time homebuyer’s expenses. If these criteria weren’t met, the regular IRA might be the better investment. You expect your tax bracket to decrease significantly when you retire. If you expect that your tax bracket will be at least 10 points lower when you retire than when you make contributions, the regular IRA offers the advantage of a current tax deduction. Taxes paid on distributions at a later date will be made at the lower tax rate, creating a larger after tax accumulation. You are not financially able to make the full allowed contribution. A smaller investment in a Roth IRA will not realize as large a benefit from compounding interest and tax-free accumulation. The up-front tax deduction offered by the traditional IRA may be financially advantageous. Consider this scenario carefully, however. What are your future investment plans? You are rolling money over from a traditional IRA to a Roth IRA and you don’t have money to pay the taxes on the IRA distribution or you are married but filing a separate return. Funds can be rolled over from a traditional IRA to a Roth IRA, and will not count toward adjusted gross income if the transfer is completed within 60 days. Important note: This is a summary and, as such, it is not intended as a complete explanation of all applicable situations. Many exceptions, definitions, and special rules in the law have been paraphrased, simplified and/or omitted. Readers should not take specific action in reliance on this summary without consulting the statute and regulations or seeking advice from a qualified professional.

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Roth IRA — Is it the Best IRA for You?