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What is a Roth IRA

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So what exactly is a Roth IRA?  (Other than one more confusing term for investing).

History (short and sweet):

Back in 1997 congress put together a bill called the Taxpayer Relief Act of 197.  One of the great things to come out of this was a new IRA, called the Roth.  (Named for the Senator that pushed for it’s creation.)

Roth IRA Basics:

An Roth IRA is not actually an investment, such as a stock or a bond is an investment. Instead an Roth IRA is an account where you hold your investments.

Why the special account? IRA’s as a whole were designed to be used as a retirement savings tool that protects your investments from taxes and you getting at the money before it is retirement time.

The best way that I have heard to describe it is that it is a coat that you wrap around your investments. Why would your investments need a coat?

Just like a real coat protects you from the cold, an IRA is protecting your money from taxes. The less you pay in taxes the more your money will grow due to compounding.

Benefits of a Roth IRA:

  • The money in the account grows tax free. Any gains on investments outside a tax sheltered account will be taxed the year you receive the income. In a Roth IRA you don’t pay taxes on those gains – ever. This allows your money to have more to compound with!
  • Creates a stop and think barrier before you take the money out before it is time! If you make a withdrawal before the age of 59 1/2 then there is a penalty of 10%, a hefty penalty to tap you’re saving before it is time, thus making it more attractive to leave the money to sit and grow. (There are ways around this 10%, either call your CPA or check out this article at Fool.com)
  • You do not have to begin taking money out – ever.

Other Details about the Roth IRA:

  • The money you put in a Roth IRA does not earn you a tax deduction.  So you pay taxes on it today.  This is one of the reasons you never have to take money out, as the government already collected taxes and does not take any taxes on your gains.  Therefore there is no need to have you take money out!
  • You can put any investment into an IRA – stocks, bonds, mutual funds, savings account, CD’s, even rental properties.
  • Most traditional accounts are held at a bank or brokerage company. Self directed IRA’s are typically at specialty custodian companies.
  • The contribution limit for 2012 is $5,000 for those under the age of 50. For those over 50 it is $6,000 (Check the IRS website for future year’s contributions.)
  • Contributions cannot exceed your income for the year. So even if the limit is $5,000 if you only made $4,000 you can only put in the $4,000.
  • There are also limits to how much you can make and qualify for opening a Roth.  You can find those limits here: IRS Roth Limits.  If you do not qualify you may want to consider the non-deductible IRA.
  • You and your spouse can have separate IRA’s (Roth or Traditional). You can contribute to a stay at home spouses account as long as one spouse has the income to cover both people’s contribution. So if you make $10,000 you can fund an IRA for both your spouse and yourself. If you made $8,000 you could fully fund one and then $3,000 of the other persons.
  • No age limit to start a Roth IRA, only requirement is that you have income. So your high school kids has a summer job, they can open a Roth IRA. The benefits of this are huge, as that money then has a really long time to grow! For example if your child was 16 and put in $5,000, made 8% on the money until they were 65 it would be $248,745 and that is if they never added another penny! (Plus that would be tax free since he/she already paid taxes on it – which as a child is low!)
  • You can contribute for the current year up until April 15th of the next year (the tax deadline).   This allows you time to work with your accountant to see the impact of deductions and a possible savers credit (credit from IRS for contributing to retirement).

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