Why You Should Open a Roth IRA
Use this versatile account to get tax-free income and a whole lot more.
Like the kitchen gadgets advertised on late-night TV that can slice, dice and turn radishes into roses, the Roth individual retirement account is an amazingly versatile product.
Its primary purpose is to provide a tax-advantaged way to save for retirement. But unlike other retirement-savings accounts, Roths let you use the money for a variety of purposes without triggering crippling taxes or early-withdrawal penalties.
Protect your savings from taxes. Investing in a Roth won't reduce next year's tax bill because Roths are funded with after-tax dollars. The payoff comes later. Once you're 59 1/2 and have owned the Roth for at least five years, withdrawals are tax- and penalty-free. That's not the case with traditional IRAs and 401(k) plans. Investing in those accounts will lower your tax bill in the year of the contribution, but future withdrawals will be taxed at ordinary income tax rates, which currently range from 10% to 39.6%.
![https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-200-80.png](https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-320-80.png)
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
That makes Roths particularly attractive for young workers. If you're just starting out, you're probably in a low tax bracket, which makes the upfront tax savings of a deductible IRA less valuable. A Roth, however, promises decades of tax-free earnings growth. And if you find yourself in a much higher income tax bracket when you retire, your tax-free withdrawals will be all the more valuable.
In 2013, you can contribute up to $5,500 to a Roth IRA (or $6,500 if you're 50 or older). You may invest in both a Roth IRA and a 401(k) plan. And if you can afford to do both, you should (but above all, be sure to take advantage of any employer matches for 401(k) contributions). Holly and Greg Johnson, who live outside Indianapolis and blog about their finances at www.clubthrifty.com, opened Roth IRAs a couple of years ago to supplement their 401(k) plans. "We wanted to save more, and we wanted to do it in a tax-diversified way," Holly says.
Tap funds in a pinch. Once you invest in a Roth, you should leave the money alone until you retire. But if you need money in a pinch, you may withdraw the amount of your contributions at any time, for any reason, without paying taxes or penalties.
If you withdraw earnings from your Roth before age 59 1/2, you'll usually pay taxes on that money, along with a 10% penalty. But there's an exception for first-time home buyers. If you've owned the Roth for at least five years, you may withdraw up to $10,000 in earnings for the purchase of a home without paying taxes or penalties. Plus, your contributions come out tax- and penalty-free even before you begin to tap into earnings.
If you tap your Roth to pay for a child's college costs, you'll owe taxes if you dip into earnings, but you'll be spared the 10% early-withdrawal penalty. "As an all-purpose starter savings vehicle, it's hard to beat," says Christine Benz, director of personal finance for Morningstar.
Leave money to your heirs. Roths also offer estate-planning benefits for older savers who have other sources of retirement income. With traditional IRAs, and generally with 401(k) plans, you must take annual minimum distributions once you turn 70 1/2. But Roths have no required withdrawals, so you can allow the account to continue to grow tax-free for your heirs. The Roth will be included in the value of your estate for estate-tax purposes, but your heirs will be able to take tax-free withdrawals over their lifetimes. (Withdrawals from inherited traditional IRAs are taxed in the heirs' top tax bracket.)
What's the catch? Unfortunately, people who can afford to leave money to their children are often ineligible to contribute to a Roth. In 2013, married couples who file jointly can contribute the maximum to a Roth if their modified adjusted gross income is less than $178,000. Those with MAGI of up to $188,000 can contribute a reduced amount; those with MAGI of $188,000 and above are disqualified. Single taxpayers with MAGI of up to $112,000 can contribute the maximum; those with MAGI up to $127,000 can contribute a reduced amount, and those with $127,000 and above are ineligible.
There's a way around this problem, but it's complex and requires considerable planning. The law allows anyone, regardless of income, to convert a traditional IRA to a Roth. The catch is that you must pay taxes on all pretax contributions and earnings. If you have enough money to live on in retirement and intend to leave the IRA to your kids, a conversion may be worth the cost (especially because the tax bill you pay will reduce the size of your taxable estate). But if you plan to withdraw the money for retirement expenses in 15 years or less, you'll have less time to benefit from tax-free earnings growth and the savings from tax-free withdrawals may not be sufficient to offset the tax you'll pay on the conversion, Benz says. Be aware, too, that because an IRA conversion would increase your taxable income, it could affect everything from eligibility for college financial aid to taxes on your Social Security benefits.
Some high-income investors have gotten around contribution limits through what's known as a "back door" Roth IRA. With this strategy, you contribute to a nondeductible IRA using after-tax dollars, then convert that IRA to a Roth. As long as you act before any earnings accumulate, you won't owe tax on the conversion—unless, that is, you also have one or more other traditional IRAs. In that case, your tax bill on the conversion will be based on the percentage of taxable and tax-free assets in all of your IRAs. If you rolled over a former employer's 401(k) to an IRA years ago, Benz says, a conversion could trigger an unexpected tax bill.
Suppose you contribute $5,000 to a nondeductible IRA, then immediately convert it to a Roth. And let's say you also have another traditional IRA that holds $95,000 from contributions, a 401(k) rollover and earnings. Because the nondeductible contribution represents just 5% of the new total of $100,000, only 5%, or $250, of the $5,000 conversion will be tax-free.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
Block joined Kiplinger in June 2012 from USA Today, where she was a reporter and personal finance columnist for more than 15 years. Prior to that, she worked for the Akron Beacon-Journal and Dow Jones Newswires. In 1993, she was a Knight-Bagehot fellow in economics and business journalism at the Columbia University Graduate School of Journalism. She has a BA in communications from Bethany College in Bethany, W.Va.
-
How Much Life Insurance Do You Really Need?
Here's an example of what life insurance coverage would look like, with actual dollar amounts, for a hypothetical family with a mortgage and student debt.
By Andrew Rosen, CFP®, CEP Published
-
Five Money Lessons From a Dad — and a Financial Adviser
Hey, parents: Do you have a clear plan for teaching your kids about money? Get started now, with a little help from a friendly financial adviser father.
By Frank J. Legan Published
-
Medicare Basics: 11 Things You Need to Know
Medicare There's Medicare Part A, Part B, Part D, Medigap plans, Medicare Advantage plans and so on. We sort out the confusion about signing up for Medicare — and much more.
By Catherine Siskos Last updated
-
Six of the Worst Assets to Inherit
inheritance Leaving these assets to your loved ones may be more trouble than it’s worth. Here's how to avoid adding to their grief after you're gone.
By David Rodeck Last updated
-
403(b) Contribution Limits for 2024: Good News for Teachers
retirement plans Teachers and nonprofit workers can contribute more to a 403(b) retirement plan in 2024 than they could in 2023.
By Jackie Stewart Last updated
-
SEP IRA Contribution Limits for 2024
SEP IRA A good option for small business owners, SEP IRAs allow individual annual contributions of as much as $69,000 a year.
By Jackie Stewart Last updated
-
Roth IRA Contribution Limits for 2024
Roth IRAs Roth IRA contribution limits have gone up for 2024. Here's what you need to know.
By Jackie Stewart Last updated
-
SIMPLE IRA Contribution Limits for 2024
simple IRA The SIMPLE IRA contribution limit increased by $500 for 2024 and workers at small businesses can contribute up to $16,000 or $19,500 if 50 or over.
By Jackie Stewart Last updated
-
457 Contribution Limits for 2024
retirement plans State and local government workers can contribute more to their 457 plans in 2024 than in 2023.
By Jackie Stewart Published
-
Roth 401(k) Contribution Limits for 2024
retirement plans The Roth 401(k) contribution limit for 2024 is increasing, and workers who are 50 and older can save even more.
By Jackie Stewart Last updated