Know What Is Available To Save For Retirement - Part 3

Tip #82 - Know What Is Available To Save For Retirement – Part 3. In parts 1 and 2 of this series we discussed the two main vehicles for individuals to save for retirement in the US. They are a 401(k) at work (or 403(b) if you work for a non-profit) and an Individual Retirement Account (IRA) – both traditional and Roth that you set up on your own. We discussed the 401(k) in Part 1 and last time we discussed the traditional IRA. Today we will discuss the Roth IRA.

About 10 years ago, a variation of the traditional IRA was introduced. This IRA is called a Roth IRA. The main difference between a Roth IRA and the traditional type is that the money that you contribute to a Roth IRA is not tax deductible. That is, you pay taxes on this income before you put it into a Roth IRA.

However, an advantage of the Roth IRA over traditional IRAs or traditional 401(k) plans is that all of the earnings you make inside the Roth IRA are tax-free for good. (Earnings on Individual IRAs and 401(k)s are just tax deferred – you pay taxes on the earnings when you withdraw them.) There are restrictions to this, of course. The money has to be in the account for at least 5 years and you have to be at least 59 ½ years of age to withdrawal. This means that if you put $5,000 into a Roth IRA mutual fund at age 50 and at age 60 when you withdraw it, it is worth $7,000, you don’t pay taxes on that $2,000 earnings.

Another advantage of a Roth IRA over a traditional IRA is that you can withdraw your contributions at any time without penalty – remember you already paid tax on these contributions. (Money withdrawn on a traditional IRA incurs taxes and penalties if you withdraw before 59 1/2.). Also, there are no restrictions on when you have to withdraw the money by as in a traditional IRA (where you have to withdraw the money by age 70 1/2). And like a traditional IRA, the advantage of a Roth IRA over a 401(k) is that you can direct where your investments go. You are not limited to your company’s investment choices.

One of the main reasons people invest in Roth IRAs, in addition to the advantages mentioned above, is that if they expect that their tax rate will be higher in retirement, they would rather pay taxes now, while their tax rate is lower. The main disadvantage to the Roth IRA is that you do not get a tax deduction on your contribution like you do with a traditional IRA, so you do not decrease your tax burden in the year you invest. Therefore, the Roth IRA is best used if you are in a lower tax bracket now but expect to be in a higher bracket when you withdraw the money. Another disadvantage to the Roth IRA is that it is not available to people above a certain income threshold.

In the last segment of this series, we will discuss in which of the different retirement options to invest – the 401(k), the traditional IRA, or the Roth IRA or a combination. (If you are self employed, you can invest in a SEP IRA. Your contributions are limited by how much income you make and are detailed here.)

In Real Life – When I first started contributing to an IRA, only a traditional IRA was available. Then in 1997, the Roth IRA was introduced. At the time IRA contributors were allowed by law to convert our traditional IRA into a Roth IRA if we wished. I was advised to do so since I was in a low tax bracket. Therefore, I converted all of my traditional IRAs to Roth IRAs and I paid taxes I owed on them. Nowadays, you can choose each year whether to invest in Roth (if you qualify), a traditional IRA or a combination of both as long as the combined contribution does not exceed $5,000 (or $6,000 if you are 50 or over). (If you are below a certain income level, you can also convert your current traditional IRA to a Roth IRA and in 2010 even those with high incomes can convert Individual IRAs to Roth).

Currently, I put the maximum I can ($5,000) per year in a Roth IRA and I have ceased contributing to the traditional IRA. I was advised that because I am in a lower tax bracket and since the future tax rate is unknown and may very well be higher when I retire, that it would be wise to invest in a Roth IRA over the traditional IRA. Also, because the earnings in the Roth are tax-free, I decided to contribute to a Roth IRA. However, everyone has to look at his or her own situation to see what is right for them. We will discuss all of the retirement vehicles as a whole in the next post.