The Roth IRA For Dummies

Created relatively recently (by the Taxpayer Relief Act of 1997), the Roth IRA has become the goto retirement savings vehicle of choice almost overnight. Indeed, for most investors the tax treatment of a Roth IRA (or Roth 401k if you have access) probably makes it a superior choice over the older tax-deferred Traditional IRA or 401k. Here’s a quick “Roth IRA For Dummies” style overview of the least you need to know about these retirement accounts.

Roth IRA Basics

Let’s first clear up one seemingly-common misconception: a Roth IRA is merely a type of account. It’s just a shell within which investments get certain tax benefits they wouldn’t otherwise qualify for. A Roth IRA is not itself an investment, so any discussion of “Roth IRA rates” is meaningless. A Roth IRA is not an investment and doesn’t earn a return. Rather, a Roth IRA holds investments which (hopefully) earn a return over time. Now that we’ve gotten that out of the way, on to the Roth guidelines…

1. Roth IRA Contributions are not tax-deductible – Unlike Traditional IRA’s or 401k’s, you don’t get a tax benefit when you contribute to a Roth IRA (or Roth 401k). This makes them less attractive to investors in the highest tax brackets but it’s not really much of a disadvantage to investors with low-to-medium incomes, for the follow reason…
2. Roth IRA withdrawals are completely tax-free – Not tax-deferred. Completely tax-free. Meaning you’ll never pay a dime in taxes on your earnings. That’s a pretty good deal.
3. Relatively small contribution limits compared to a 401k – Roth IRA’s are such a great deal, Uncle Sam had to put a cap on how much you could invest in a Roth in any given year. The contribution limit for both Roth and Traditional IRA’s in 2011 is $5,000 (indexed to inflation going forward). Contrast that with the much greater $16,500 contribution limit for 401k’s.
4. Old people can invest more – Investors age 50 and above are eligible to contribute an extra $1,000 per year for a total of $6,000. Gee, thanks Uncle Sam!
5. You’ll owe a 10% penalty if you withdraw earnings before age 59 1/2 – Don’t ask me why they chose 59 1/2 over, say, 59 or 60. I have no idea. Nonetheless, if you withdraw any of your earnings before the magical age you’ll owe a 10% penalty to the IRS. It’s best not to do that.
6. Rich people can’t contribute - The IRS doesn’t want rich people to have access to tax-free growth, so they enforce income limits. If you’re single and earn over $107,000 or married and earn over $169,000 your eligibility to contribute to a Roth IRA begins to phase out. Sorry, moneybags.
7. No required minimum distributions – Unlike Traditional IRA’s and 401k’s, the IRS doesn’t force you to withdraw money from your Roth IRA if you don’t want to. You can let your wealth accumulate tax free for as long as you live.
8. Pass money to your heirs tax-free - A Roth IRA is probably the simplest and most efficient to pass on money to your heirs tax-free when you die. If you set up your beneficiaries correctly, your Roth will bypass probate and by extension the estate tax.