Roth IRA Basics

| June 13, 2011 | 3 Comments

An individual retirement account (IRA) is a catch-all phrase for a type of retirement plan which provides tax advantages for retirement savings in the United States. There are multiple types of retirement plans that fall under this category. However, one of the most recently established, the Roth IRA, has become overwhelmingly popular due to its simplicity and effectiveness.

What is a Roth IRA?

The Roth IRA was established by the Taxpayer Relief Act of 1997 and is named for it’s chief legislative sponsor, the late Senator William Roth of Delaware. Much like other IRAs, the Roth IRA allows for contributions to earn interest and grow without incurring any taxes. A Roth IRA can be comprised of various investments in stocks and bonds. Mutual funds are the most typical investment option, but there are other possibilities such as derivatives, notes, certificates of deposit and real estate. The Roth IRA offers the least restrictive investment options among IRAs, but the investment options depend on the financial institution where the plan is established.

Contributions to a Roth IRA can only be made with post-tax dollars. In other words, contributions can only be made using the money you receive after taxes have been taken out of your paycheck. This is the complete opposite of a Traditional IRA, which requires contributions to be made with pre-tax money.

The total Roth IRA contribution amount allowed per year can vary on a yearly basis depending on changes made by Congress (see below for recent limits). The total allowable Roth IRA contribution also depends upon your annual income, such that individuals who earn less than the limit can only contribute an amount up to their taxable income.

Roth IRA Contribution Limits from 2008 to Present (2011)

  Age 49 and Below Age 50 and Above
2008 - present $5,000 $6,000

For example, if you’re single, age 26, and earn $50,000 per year, you can contribute a maximum of $5,000 to your Roth IRA this year. However, if you are single, age 26, and earn $4,000, you can only contribute up to $4,000 to your Roth IRA this year.

Roth IRA Eligibility

Congress has limited who can contribute to a Roth IRA. The limitations are based upon income. A taxpayer can contribute the maximum amount (listed above) only if their Modified Adjusted Gross Income (MAGI) is below a certain level (shown below):

  • Single filers: Up to $105,000 (to qualify for a full contribution); $105,000–$120,000 (to be eligible for a partial contribution)
  • Joint filers: Up to $169,000 (to qualify for a full contribution); $169,000–$179,000 (to be eligible for a partial contribution)
  • Married filing separately (if the couple lived together for any part of the year): $0 (to qualify for a full contribution); $0–$10,000 (to be eligible for a partial contribution).

As with most retirement accounts, money cannot be withdrawn from a Roth IRA without penalty before the age of 59.5.

Roth IRA Advantages

Roth IRA contributions can grow and be eventually withdrawn without incurring any additional taxes. This represents the primary advantage of the Roth IRA. Unlike other IRAs, such as the Traditional IRA, which require your money to be taxed as it’s withdrawn, Roth IRA contributions are taxed once (at the moment of contribution) and never again. This is a tremendous advantage for people who expect to be promoted a few times in their career, since they will be in a higher tax bracket when they retire and withdraw funds held in their Roth IRA.

Roth IRA vs Traditional IRA

In order to compare a Roth IRA to a Traditional IRA, consider the case of Jane, a 24 year-old accountant earning $45,000 per year. We will base our calculations on the income tax rate table for 2011.

Income Tax Rate Table for 2011

  Single Married - Joint Head of Household Married - Separate
10% 0 - 8,500 0 - 17,000 0 - 12,150 0 - 8,500
15% 8,500 - 34,500 17,000 - 69,000 12,150 - 46,250 8,500 - 34,500
25% 34,500 - 83,600 69,000 - 139,350 46,250- 119,400 34,500 - 69,675
28% 83,600 - 174,400 139,350 - 212,300 119,400 - 193,350 69,675 - 106,500
33% 174,400 - 379,150 212,300 - 379,150 193,350 - 379,150 106,500 - 189,575
35% 379,150 and Up 379,150 and Up 379,610 and Up 189,575 and Up

Jane’s 2011 taxable income is $45,000, so she is in the 25% tax bracket. If Jane gets a 5% raise each year and continues plodding away at the same company, she will be in the 28% tax bracket by age 37. Most of us won’t exceed the 28% tax bracket (based on census data), but for demonstration purposes, if we extend the 5% raise scenario further, Jane would be in the 33% tax bracket by age 52.

Now imagine that the 24 year-old Jane contributed $5,000 in a Traditional IRA and never touched it again. She earned a raise of 5% every year (as described above) until she was eligible to withdraw money from the IRA when she was 59.5 years-old. The $5,000 Jane invested in a good mutual fund, when she was 24, would now be worth approximately $76,883 (assuming 8% annual growth). However, Jane would not be entitled to all that money. If it was in a Traditional IRA, Jane would owe taxes upon withdrawing the money. Since Jane made it to the 33% income tax bracket before retirement, the government would take a whopping $15,345 in taxes as she withdrew the money!

If Jane had put the $5,000 dollars in a Roth IRA when she was 24 years-old, she would not owe the government a dime when she withdrew the funds. Keep in mind that the $5,000 was an after-tax contribution, so Jane really had to earn almost $6,000 before having the $5,000 to contribute (after taxes were taken out of her paycheck). Therein lies the trade off between the Roth IRA and an alternative like the Traditional IRA. The Roth IRA contributions will be taxed “up front” while the Traditional IRA will be taxed “on the back end” or as you withdraw money.

There must be a string attached, right? The Roth IRA seems like such an obvious choice. However, there are a few disadvantages to a Roth IRA and everyone’s financial situation is different, so it’s may not be the best retirement solution for you.

Roth IRA Disadvantages

Despite all the advantages mentioned above, Roth IRAs also have their disadvantages. For one, contributions to a Roth IRA are not tax-deductible. This in contrast to the Traditional IRA, for which contributions are tax-deductible (within income limits).

As mentioned above, taxpayers will eventually be ineligible to contribute to a Roth IRA because of the income limits. Some consider this a disadvantage in comparison to most tax-deductible employer sponsored retirement plans that have no income limit. However, this is simply the nature of a Roth IRA, and wise investors should consider alternative retirement saving plans as they reach higher income levels.

Conclusion

Everyone’s financial situation is different, so a Roth IRA does not suit everyone’s needs. However, as a general rule, if you are young and beginning an upwardly mobile career, you owe it to yourself to open a Roth IRA. For more information on how to set up an account, contact the benefits manager at your employer to determine which IRA options are available to you at work. If your employer doesn’t offer a retirement plan, there are literally hundreds of banks, brokerage firms, and mutual fund companies you can choose from to help you open an IRA account.

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Category: Retirement

Comments (3)

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  1. One technical point–you said that money cannot be withdrawn from a Roth IRA without penalty before the age of 59.5–there is a split in there. Income accumulated on investments are subject to both tax and penalty if withdrawn before age 59.5. But contributions are subject to neither since they were funded out of after tax income.

    That’s one of the big advantages of the Roth, your money isn’t necessarily tied up the way it is with other retirement plans.

  2. […] s1); })(); Even if you’re a twenty-something, just starting to invest in your Roth IRA, it’s important to have at least a simple retirement goal in mind. The famous Yogi Berra said […]

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