A few of years ago I got my first Roth IRA. I didn’t know what it was or even how to pronounce it. I found myself asking, what does IRA stand for? Ross from the TV show Friends is what always came to mind, and he didn’t have a Roth IRA that I know of. My friend was telling me about this Roth IRA and he did a great job explaining it. By the time he got done I was ready to sign up. Hopefully when you get done reading here you’ll want to do the same.
Let’s get started. Roth IRA’s were introduced to the public in 1998. The Roth IRA was part of the Tax Relief Act of 1997. This is one program where the government actually did some good for middle-class Americans.
As we review the benefits, you’ll see how Roth IRA’s can be a welcomed addition to your retirement/savings portfolio.
The rules of a Roth IRA are quite simple. You invest after tax dollars. These are your contribution dollars. You can invest in stocks, bonds, mutual funds, metals; investment choices are quite liberal. The vesting on your principal is five years. This means you can withdraw (your contribution) from your principal after five years, without penalties. Any earnings in a Roth has to be held in the account until age 59 1/2 for it to be penalty free.
Each year there is a contribution limit and for 2013:
- Roth IRA $5,500 ($6,500 if you’re age 50 or older)
- Roth 401K $17,500 ($23,000 if 50 or over) via salary deferral
This makes a grand total of $23,000 in 2013.
Exemptions: Down payment on a house, collage education, medical expenses are all qualified exemptions. What does this mean? Under current IRS rules, any of your principal and earnings that qualify for the five year vesting period can be used for the above purposes without penalties or taxes. This is really great! And something you don’t find in to many other investment vehicles available to the average person.
I personally used this exception when I purchased my home.
note: These exemptions do not apply to the Roth 401k
At 59 1/2 your earnings accumulated in a Roth IRA are tax free. Yes, you heard it right – tax free.
Another things is, unlike a traditional IRA where you have to take mandatory withdrawals at age 70 1/2, you do not have this restriction with a Roth IRA.
Do you need anymore reasons for why you need a Roth IRA?
Taking a Risk
There’s no disagreement that your first investment choice for retirement should be your employers 401k plan. Especially if your employer has implemented some type of match. And now we have a Roth 401k. Definitely check with your employer for this option. I do this and my Roth IRA comes second.
The debate now rages whether a Roth IRA is better than a traditional IRA. There are so many different situations among investors that it cannot be covered in one blanket statement, but here’s something to think about.
For a side by side comparison of Traditional and Roth IRA’s read my previous article.
Convert your Traditional IRA to a Roth IRA. A Roth offers two gigantic benefits for people willing to take some risk, and you can take a small portion of your traditional IRA to do this. As discussed, a Roth IRA has liberal investment choices when working with a broker. You can invest in individual stocks or other aggressive investments. Then we have the benefit of “no taxes” on the earnings (remember the qualifications).
The money you convert from a Traditional IRA to a Roth is subject to ordinary income tax, this is the downside. If you do a conversion in a tax year where your tax bracket is low, then this could be even better for this strategy.
Your age, your retirement strategy, and your risk adversity all play a role in the conversion strategy.
Opening a Roth IRA
The following are basic steps for opening a Roth account:
1. Choose a broker, bank, or other institution for the account
2. Check for current Roth income limits (IRS)
3. Check for current contribution limits (also governed by the IRS)
4. Select investments
Your investment choices are limited with banks, so to maximize the benefits offered by Roth IRA’s you should take a closer look at opening an account with a reputable broker house.
Who might benefit from a Roth IRA?
- Those financially well-prepared for retirement
- Are Maximum Savers
- Are in a lower tax bracket today than projected to be in the future
- Have beneficiaries in mind
Who might not benefit from a Roth IRA?
- Those who are not “on track” for retirement
- Have fluctuating income
- Have children, income between $20k and $50k, and qualify for either the earned income credit or the additional child tax credit.
- Those who expect to live off social security in their golden years.
Do you need a Roth IRA? It should definitely be a part of your retirement portfolio. This is one of the few government approved investment vehicles that give the average person a chance at really enhancing their retirement egg – take advantage of it while you can.
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Editor’s Note: John is not a registered financial advisor and writes from his personal experience through reading, studying and managing his own finances. All of our financial situations are different and this is just a basic introduction for your own personal knowledge.