Roth IRA – the greatest thing since sliced pizza

The Roth is one type of IRA, or Individual Retirement Account (fun Trivial Pursuit fact, they were first, and still, called Individual Retirement Arrangements). The extraordinary thing about the Roth is that withdrawals – done correctly – are tax-free!

Here's the lowdown – and as always, check with someone, preferably a tax professional, who knows your specific situation better than an anonymous blogger. :-) Also, check out http://www.irs.gov/ for the official scoop.

Like all IRAs, the Roth has to be opened correctly. Specific forms, etc. They can be through a bank, credit union, brokerage, or other financial institution (personal gripe – a lot of people still think you can only have an IRA through a bank,and only “invest” in CDs!).

Contributions:
In traditional IRAs, you can add money, called contributions, and that money can usually be deducted from this year's income for tax purposes. In a Roth, you do lose the deductibility of your contributions.
There are limitations on the contributions you can make in a year (for 2008, it is $5,000, or for those 50 and older, $6,000). After 2008, the maximum contribution will be adjusted upwards based on a cost-of living adjustment.
If you have too high an earned income then the amount allowed to be contributed is lowered and finally gets completely chopped off. For 2008, the amounts at which you start being phased out, and then stopped are $101,000 to $116,000 for singles and married filing separately (and living apart); $159k to $169k for married filing jointly; for married filed separately but living together, the rather draconian numbers are $0 and $10,000.
You can contribute to a Roth until age 70 ½, and even if you have a retirement plan offered at work.

Tax Deferred Earnings:
Okay – you have money in the IRA – now what? Like all IRAs, the earnings compound tax-deferred. This is Uncle Sam's way of thanking you for planning your own retirement – anything earned this year will not be taxed this year! Think of it this way -- if you earned $50,000 at your job, you get taxed on that $50,000. But if your IRA earned $50k, then the entire amount goes to work for you the next year.

Withdrawals:
Now, in a traditional IRA, when you take withdrawals, those withdrawals count as income and are taxed. In a Roth, however, since you added to the account with after-tax money, all the contributions and earnings get special tax treatment. All withdrawals are tax free! * Remember, in a Roth, you also can take contributions out penalty-free (and tax-free) anytime.
Now, like all IRAs, the Roth does penalize early withdrawals – if you take the earnings out before you get to age 59 ½, then you pay a 10% penalty along with that withdrawal being taxable.

I will need to write another time about some other special-circumstance things like taking earnings out for first-time home purchases, and the rules for re-characterizing a traditional IRA to a Roth.

* Assuming they are not early withdrawals.

Regards,
Trond