ROTH IRAs, which first became available in 1998, provide an exciting opportunity to set aside up to $4,000 per year as an investment and to let it grow tax free. The $4,000 set aside does not give you a deduction for tax purposes; that's "bad" compared to most of the other arrangements discussed later in this paper. The earnings on that $4,000 investment will accumulate tax free; that's the same as most of the other arrangements discussed below. Now here's the beauty of the ROTH: when you or you grandchildren take the money out of the ROTH for personal living purposes, the accumulation - not just the $4,000 but the accumulation on that $4,000 investment also - is not subject to Federal income tax; and that's very "good" compared to most of the other plans discussed below. To get this accumulation tax free you must meet certain conditions discussed below.
(The $4,000 is the maximum annual Roth contribution in years 2005, 2006 and 2007. The number increases to $5,000 in 2008.
Let's put this in perspective by dealing with a simple example. Suppose Jane puts $4,000 into her ROTH at the beginning of the current year and let's say the $4,000 can earn interest, dividends or other investment income of 10 percent per year compounded annually. At 10 percent compounded annually, money doubles in seven years. By the end of year seven, her $4,000 will amount to $8,000; by the end of year 14, it's $16,000; by year 21, it's $32,000; by year 28, it's $64,000; by year 35, it's $128,000; by year 42, it's $256,000. Jane made the investment at age 23 and now she's 65 and wants to retire and live high. She takes the $256,000 out of her ROTH where it has been growing tax free for 42 years. Bear in mind that $252,000 of that $256,000 is the interest and dividends she's been earning. She pays no tax on that $252,000! And that's from one investment of $4,000! No wonder Keynes called compound interest the 8th Wonder of the World. (He wasn't talking about tax-free accumulations but it's extra "Wonderful" if the money is accumulating tax free.)
Incidentally, Jane isn't satisfied with a single investment of $4,000. Starting at age 23, she made these investments every year up to and including the beginning of the 42nd year. Would you care to guess what her accumulation is by this time? If the contributions were $4,000 per year for all of those years, her accumulation would be $2,772,000 and bear in mind that she contributes $5,000 - not $4,000 - in 2008 and higher amounts in subsequent years if the maximum contribution continues to go up. If she started making these contributions in 2005 when she was 23 the accumulation might - assuming Congress doesn't eliminate Roths - she is likely to have $4,000,000 or more in her account. (And Jane can't even play basketball!).
Tom makes a one-time investment of $4,000 in a ROTH IRA when he is also 23 years old. Tom's investment earns only six percent per annum compounded annually. At six percent compounded annually and growing tax free, it will take twelve years for his money to double. Tom figures he will need the money when he is 71 years old which is 48 years from now. To how much will his original $2,000 have accumulated by the end of the 48th year? Click on one of the buttons.
Yes, there's quite a difference between Tom and Jane. Tom has to wait longer to get his money and, when he gets it, it is less than Jane gets. He will get $32,000 (choice c) by waiting 48 years but she gets $128,000 by waiting only 42 years. This demonstrates that a higher interest rate compounded for an extensive period of time will easily beat a lower interest rate compounded also for a lengthy period of time.
But even Tom does rather well because he is accumulating his earnings tax free. If Tom were in the higher tax brackets, his six percent would only amount to perhaps four percent after tax. (Bear in mind that marginal federal tax rates are close to 35 percent - 2006 if Congress does not change them - and the state tax rate, net of its impact on his federal tax, further reduces the accumulation.) At four percent compounded annually, his $4,000 would double in about 18 years. After 18 years, Tom would accumulate $8,000 net of tax, after 36 years it would be $16,000 and after 54 years it would be $32,000. Accumulating tax free at six percent Tom would have $64,000 after 48 years; but accumulating net of tax at four percent, Tom would get only half as much, or $32,000, and would have to wait 54 years, or six more years, to get it. Accumulating earnings net of tax makes quite a difference.
Let's learn a little more about the circumstances in which Tom and Jane can accumulate money tax free. First, the amount they can set aside tax free is only $4,000 per year (2007). Second, to be able to set aside this money to accumulate tax free, they must have "earned income" of $4,000 or more. "Earned income" refers to salary, earnings from self employment and similar types of income. If their earned income is only $900 then all they could put into a ROTH IRA would be $900. If it was $760, then the maximum ROTH IRA contribution would be only $760, etc.
There are income limits on the ability to contribute to a Roth IRA. The $4,000 maximum contribution to a Roth is phased out for single taxpayers with adjusted gross income (AGI) over $95,000 and for joint filers with AGI over $150,000. For a single taxpayer take the amount by which $110,000 exceeds "modified" AGI and divide that excess by 3.75 to determine the maximum contribution that can be made during the year to a Roth IRA. Suppose, for example, Jane has $95,000 of AGI. The excess of $110,000 over $95,000 is $15,000 and this excess divided by 3.75 is $4,000 and Jane can make the maximum contribution of $4,000 to a Roth. If Jane had had $102,500 of AGI, the excess of $110,000 over $102,500 would be $7,500 and this excess divided by 3.75 is only $2,000; the most Jane could contribute to a Roth for the year in this circumstance would be $2,000. Similar calculations apply for joint filers except that the phaseout starts at $150,000. For single taxpapers, the ability to make a Roth contribution for a particular year is completely phased out if AGI is $110,000 or more and for joint filers it is phased out if AGI is $160,000.
Furthermore, the amount Tom and Jane put into a ROTH reduces the amount they can put into a traditional IRA. If they qualify for a traditional IRA contribution of $4,000 (see below), but they put $1,200 into a ROTH IRA, then the amount they can put in the traditional IRA is reduced to $2,800.
Why would Tom or Jane want to put money into a traditional IRA rather than a ROTH IRA? Both the ROTH and the traditional accumulate tax free but the traditional IRA has the advantage of giving them a tax deduction in the year they make the contribution whereas the ROTH gives no tax deduction in the year the contribution is made. That's the advantage of the traditional IRA. Against this advantage, Tom and Jane should weigh the tax advantage of the ROTH which permits them to withdraw the accumulation - if they can wait long enough as discussed below - tax free. The proceeds of the regular IRA will be taxable when withdrawn.
Suppose Jane currently pays a marginal federal and state tax which amounts to 40 percent of income. A $4,000 reduction in her taxable income through use of a traditional IRA would reduce her tax bill by $1,600 in the current year. So would she be better off to invest in the traditional IRA and get the $800 tax saving or would she be better off to invest in a ROTH IRA? Here are the alternatives she should analyze:
(a) The traditional IRA will grow tax free but in the end she'll have to pay tax on it when she withdraws it during her retirement years. Offsetting this tax, of course, are the potential earnings on the $1,600 tax saving she has. If she invests this $1,600 and let's it grow over the years it will at least in part offset the eventual tax on the $4,000 plus its accumulation that she takes out of the traditional IRA. Don't forget, however, that the earnings on the $1,600 will be subject to tax over the years.
(b) By contrast, none of the earnings on the ROTH - and not the original $4,000 either - will be subject to tax when she withdraws the money in her "golden" years. Of course, she won't get the immediate tax savings of the $1,600 and she won't have the money accumulated from investing that $1,600. As a general proposition, however, (and of course it depends on her age and tax bracket and some other variables) Jane will be better off with the ROTH even though it won't give her an immediate tax saving of $1,600.
Contributions to a Roth can be made at any age unlike contributions to a traditional IRA which cannot be made after age 70.5. Vera, age 75, couldn't contribute to a traditional IRA but she sees the Roth as an attractive way to set aside some funds she won't need in retirement and to let those funds grow for the benefit of her grandchildren.
Contributions to a Roth may be made even though you participate in a retirement plan sponsored by your employer. We'll see below that if you're covered by such a plan, you may not be able to make tax deductible contributions to a traditional IRA. The Roth contribution is not deductible which in part explains why your coverage in another retirement plan is irrelevant to your ability to contribute to a Roth.
So what's the downside to a Roth IRA and wouldn't it make sense for everyone that qualifies (as discussed above) to open a Roth? Certainly a Roth makes sense for many, many people but there are some circumstances in which a Roth is not a good idea.
We said above that a Roth accumulates earnings tax free and permits tax free withdrawal of the accumulation but that's only true if certain conditions are met. In particular, bear in mind that a Roth is designed to facilitate saving for retirement and should not be used - and loses its tax advantages - unless you set the money aside with long-term goals in mind. For the accumulation to be tax free when withdrawn, your money should stay in the Roth for at least five years and should not be withdrawn before age 59.5. If the earnings from the Roth are withdrawn before five years have passed or if the taxpayer takes the money out before reaching age 59.5 the earnings are subject to tax and there is, in addition, a 10 percent penalty. Don't open a Roth unless you can wait at least five years to take the earnings out and if you're 25 years old now, you should plan on waiting at least 34.5 years so you'll be 59.5.
Jock opened an IRA with $2,000 on December 31, year 1 and a few days later - January 2 of year 2 - adds another $2,000. He's made the maximum contribution for the two years. Let's say this $4,000 earns six percent throughout year 2 so that late in year 2 there's $4,240 in the Roth. Jock withdraws the $4,240 to finance a cruise. Careful Jock! The Roth does you no good at all. You will pay tax on the $240 earned during year 2 and, if the combined federal and state marginal tax rate is 40 percent,you will pay $96 just as you would have paid if the $4,000 were invested at six percent without using a Roth. In addition, you'll pay a ten percent penalty of $24 on the amount earned. The $96 and the $24 add up to $120 or half the amount earned. The Roth did you no good and in fact hurt you to the extent of $24.
If Jock is 60 and wants to withdraw the accumulation tax free he should plan on waiting at least five years to meet the five year requirement. If Jock is 30 he should delay the cruise at least 30 years so that he will be over 59.5 years old. The five year requirement and the 59.5 age requirement are "ANDs" and must both be met to enjoy the benefits of tax free accumulation. They are not "ORs" and it isn't enough to meet just one of them.
Having pointed out the perils of early withdrawal, however, it should be noted that there are an extraordinary number of ways in which Jock can get at his money, or at least some of it, without losing the benefit of tax free withdrawal. Note in the above example, Jock was only taxed on the $240 earned during year 2. What if Jock only took out $4,000 and left in the $240 earned on the $4,000? Money withdrawn from the Roth is considered to come first from the contribution made to the Roth rather than from the earnings; in accountant's lingo it's first-in first-out or FIFO. Jock would have no tax on the $4,000 he withdraws and the $240 would continue to accumulate tax free and be available to be withdrawn tax free at a later - much later if Jock is 30 - date. Be patient Jock!
There are also so many other ways in which money can be withdrawn from the IRA without the ten percent peanlty and some without even tax on the accumulated earnings, that it is really a little difficult to be sure that the plans really have anything to do with retirement and saving for old age. Up to $10,000 used for a first time home purchase, for example, can be withdrawn without the ten percent penalty and, assuming the five-year aging requirement has been met, will also be free of tax. Let Jock put $2,000 a year into his Roth for ten years and let there then be an accumulation of, say, $26,000. Jock now takes out $20,000 for a grand cruise and of course that's tax free because it's what he contributed. On returning from the cruise he takes out the remaining $6,000 to help with the downpayment on his first home. It's tax free because it meets the five-year aging requirement and is used for a first-time home purchase. Let's say Jock is 35 years old now. He has had tax free accumulation and also tax free withdrawal and none of it has much to do with his ultimate retirement.
Qualified higher education expenses can also be withdrawn from the Roth without triggering the 10 percent early withdrawal penalty. "Qualified higher education expenses" include, for you, your spouse and your children or grandchildren and hers, such things as tuition, fees, books, supplies, equipment and other eligible expenses incurred at a post-secondary institution for the taxable year.
It's also possible to make penalty-free withdrawals for a variety of other reasons such as major medical expenses, death or disability of the account holder, etc. These are the same as for penalty-free withdrawals from a traditional IRA and are discussed more fully in that context below.
If you want to consider the possibility of converting your existing regular IRA or CREF or 401(k) to a Roth IRA click here.
Huge amounts have already been accumulated in Roth retirement plans and it is quite possible the administration of these plans will get to be much more complex as the years pass and as the taxing authorities try to get a part of these accumulations. In particular, the early withdrawal rules may get to be much more complex and may add extra lines to your already too long personal tax return.
If somebody is to be blamed for the extra complexity of your returns and your records, it's your congressperson and mine. He/she has got the idea that it would be a good idea for the government to regulate every aspect of our lives: where we go to school; whether we smoke; when we retire; whether we plan for retirement and how we accumulate the money for retirement - you name it. And rather than blaming our congressperson why don't we blame the people who are foolish enough to elect them with platforms that promise this goodie and that gimmick. Why don't we blame you and me?
Given that complexity and formomania are characteristics of Washington, DC and also, to a lesser extent, of your state capitol and given that using a Roth will certainly increase the complexity of your tax returns (if not now, certainly if you get involved in early withdrawals), nevertheless the Roth IRA is a great opportunity for most taxpayers to let money accumulate tax free and to let it be later (much later) withdrawn tax free. Now continue to information about the "classic" or "traditional" IRA or or you can go to a complete table of contents for this site..