Roth IRA Explained

Consider a Roth IRA as a graduation gift this summer.

Yep, that’s right, a Roth IRA. Most college graduates probably aren’t thinking about retirement right now, in fact they’re just looking forward a relaxing summer followed by their first paycheck. However, as a responsible adult (ha!) you may consider giving that graduate a Roth IRA and get them started on saving for their future.

Earned Income. The rule with contributions is that a person has to earn as much “earned income” in order to contribute that to their Roth IRA. The dollar they earn doesn’t necessarily have to be the dollar they contribute so as long as your graduate will be earning money, you can probably open a Roth IRA on their behalf. If the graduate has a job, chances are he or she will have sufficient earned income to cover your Roth IRA contribution (the $5,000 contribution limit for this year).

Another side benefit of this gift is that it helps the graduate recognize the importance of retirement and lets them know about the Roth IRA, if they don’t know about it already.

It was announced today that the Pentagon supports proposed changes to the Thrift Savings Plan that would automatically sign up troops for the TSP as well as offer the Roth IRA as an investment option. The first proposed change, automatic sign-up, was recently instituted in the private sector and has resulted in increases in employee participation. It’s thought that automatic sign ups for TSPs would increase participation as the main reason people don’t sign up is due to inertia, it takes effort to.

The second proposed change involves introducing Roth IRA as an option in the TSP which would result in significant savings for deployed troops since they do not pay taxes on their earnings or bonuses while they are in war zones. With a Roth IRA, you contribute after-tax dollars and appreciation is tax free. Troops in a combat zone are in the 0% tax bracket, so they benefit tremendously from the Roth IRA option.

Those troops who are not in combat zones also benefit from the Roth IRA option because it gives them tax diversification.

DoD backs automatic TSP enrollments [Air Force Times]

If you’ve been reading a lot about Roth IRA’s, it stands to reason that you’re also potentially interested in a similarly structured retirement vehicle - the Roth 401(k). A rather comprehensive discussion of the Roth 401(k) is available at MyRetirementBlog.com but here’s a brief recap.

A Roth IRA is to a Traditional IRA as a Roth 401(k) is a Traditional 401(k). Roth 401(k) contributions are not tax deductible, grow tax free, and share the same contribution limits as the “traditional” 401(k) it’s based off. The only tricky part about a Roth 401(k) is that any employer matching contribution goes into the “traditional” bucket and not all employers offer the Roth 401(k). In fact, not many at all offer it.

Converting your Traditional IRA to a Roth IRA is a very complicated question and one that many people will start asking soon when the IRA conversion loophole opens up in 2010. Whether or not you should convert your IRA comes down to several questions and they will help you decide which one is the right course of action.

Paying For The Conversion

When you convert the Traditional IRA over to the Roth IRA, you will have to pay taxes on the amount that you convert. The tax you pay will be your marginal tax rate and you can pay with IRA funds or with outside funds. If you can’t afford to pay for the conversion outside of the IRA, it’s generally accepted that you shouldn’t do the conversion. It’s better to have the larger dollar amount sitting tax-deferred than a smaller dollar amount sitting tax-free. This is also true because your tax profile now, while you are employed, is likely going to put you at a higher bracket than in the future, when you’ll be retired. This assumes that the tax brackets will remain relatively stable, which is never a certainty.

Partial Conversion

If you can only pay for part of the conversion outside of the IRA, certainly consider it. Also be aware that while you could be in the 15% bracket, the conversion itself may have a portion pushed into the 25% bracket. You can use partial conversions to avoid this.

Traditional IRA Was Non-Deductible

If you contributed to a Traditional IRA and were not eligible to deduct the contributions because of a 401(k), your conversion of those dollars will be free (because you already paid the tax). It behooves you to take advantage of the conversion if you would otherwise be ineligible.

At one point or another you probably wondered whether you should contribute to a Roth IRA or a Traditional IRA. While I can’t tell you which one is best for you, I can tell you my own thought process and hope you can use it to decide which one is better for you.

For me, I had access to a 401(k) through my employer. A 401(k) is like a Traditional IRA, it’s a tax deferred retirement option, though I can get an employer match for my contributions. In 2008, I can contribute $15,500 towards the 401(k), far exceeding the $5,000 I can put in a Traditional IRA. Another consideration was that because I had access to a 401(k) and because my income was above the deductibility ceiling, I couldn’t deduct Traditional IRA contributions. Even if I could, I still would pick a Roth IRA because I would rather diversify my tax profile and put $15,500 (or less) tax-deferred in a 401(k) and then $5,000 tax-free in a Roth IRA.

The Roth IRA is best for when you think your current marginal tax rate will be lower than your retirement tax rate. That makes it idea for young professionals, teenagers, and new workers because you likely will earn more as you grow older. If you earn more later on, your tax rate will increase, by protecting those assets in a Roth IRA, you can shield them from the higher tax rates.

Roth IRA isn’t necessarily better than a Traditional IRA in all cases, it was simply better for me.

Here is another post on My Retirement Blog discussing how to choose between Roth IRAs and Traditional IRAs.

That’s right, you can retire with $2,583,307.74 in your Roth IRA if you start early enough, have a bit of luck on your side, and stick with it for forty years. It’s a long time, granted, and there is a chance you won’t be able to contribute to your Roth IRA for 40 years, because of income restrictions; but if you do, there is a handsome tax-free rewards for you at the end of the rainbow. If you contribute $4,000 a year and your Roth IRA investments appreciate at a rate of 11% each year, the following table shows you exactly how much you will have after how many years.

Two and a half million dollars… just for a little discipline and some luck. Are you ready to go after it?

We at Roth IRA Explained want to be a helpful and informative resource for novice and seasoned investors looking to understand all the basics of Roth IRAs, all the nuances of Roth IRAs, and all the complicated aspects of Roth IRAs - all the things that you probably wanted to know but simply couldn’t glean by reading other more complicated sites out there. I’m a regular person like you, I am not an expert investor, I’m not a tax expert, and I am not a lawyer. The things that I write may be incorrect, I might misinterpret some things, but rest assured if and when I find any errors, I seek to correct as quickly as possible.

Hopefully you will bookmark this site and turn to it whenever you have any questions!