The Roth IRA: A Closer Look at a Powerful Wealth Building Tool

by RC on June 24, 2008

The Roth IRA gets talked about quite frequently these days, as a great tool for reaching your retirement goals and building wealth. While many people are well-versed and may be experts on the Roth, for those of us just beginning our saving and investing journey, I thought it would be a good idea to touch on the basics and a few details of the Roth IRA.

What is a Roth IRA and how does it work ?

A Roth IRA (individual retirement account) is a retirement savings account which allows a person to save money for retirement which can be withdrawn tax -free during retirement, after reaching a minimum age of 59 1/2. Investments are normally made in stocks, mutual funds, index funds, or bonds, although other vehicles can be used as well. Investments are made with after-tax contributions, and as stated above all of the principal and interest can be withdrawn tax-free upon reaching an age of 59 1/2.

Roth IRA vs. Traditional IRA

In a Roth IRA, contributions are made with after-tax money, while traditional IRA contributions are tax deductible. Contributions to a traditional IRA are made with pre-tax money, but the withdrawals during retirement are taxed (both principle and interest) at you ordinary income tax rate at that time. Therefore, a Roth IRA can benefit someone who anticipates being in a higher tax bracket at retirement age. However, because contributions are made after tax, a tax-deferred option such as the traditional IRA can allow someone with a lower income the opportunity to put money away with a lower decrease in their take home income. There are no rule on the age of required minimum distributions of a Roth IRA, which is currently 70 1/2 for a traditional IRA and a 401k. (This means in a traditional IRA or a 401k, you are required to start taking out money when you reach age 70 1/2.) There are certain situations when money earned (in the form of interest) can be withdrawn as well, while the traditional IRA is far more restrictive on withdrawals. As long as the Roth has been open five years, earnings can be withdrawn if the participant becomes disabled. Contributions can be withdrawn from a Roth IRA at any time, since they have already been taxed. In some cases, up to $10,000 in earnings can also be withdrawn to acquire a principal residence.

Roth IRA Income Eligibility Rules

Income Limits for 2008

Single - Up to $101,000 (modified adjusted gross income)

Married filing jointly- Up to $159,000 for full contribution, partial between $159k and $169k

Roth IRA Contribution Limits-2008

For 2008, the maximum contribution to a Roth IRA is $5000 for those age 49 and below, and $6000 for those 50 and above. This limit is slated to increase $500 per year starting in 2009 to account for the effects of inflation. The $5000(or $6000) limit applies to all IRA contributions, so that is the max. that can be contributed to either a traditional IRA or a Roth IRA.

Roth IRA Conversion

If you have saved money in a traditional IRA, and wish to now pay tax on that money and convert it to a Roth IRA, you are able to do so if you meet the income limitation. A conversion is good for someone who has an existing traditional IRA, and has the money available to pay taxes on it now in order to eliminate future tax liability. This is especially attractive if the person anticipates being in a higher tax bracket in the future. However, only taxpayers with a modified AGI of $100,000 or less are currently eligible to convert a traditional IRA to a Roth IRA. This limitation is slated to be removed starting in 2010, so already many people are planning to do a conversion then. The tax liability will be able to be spread over 2 years (2011 and 2012), as well, which is an added bonus for many.

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