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 It has been 13 years since the Roth IRA first stormed onto the financial scene as part of the Taxpayer Relief Act of 1997. There has been plenty of marketing, information, misinformation and confusion surrounding them ever since.
If you don't have a Roth IRA, 2010 might be the year you want to consider opening or converting to one.
IRAs and Roth IRAs are both types of accounts in which individuals can save for retirement. Both are designed to help your savings grow faster by not taxing the interest and earnings in your account along the way. Anyone who has received a 1099-INT from their bank knows you must pay taxes on any interest you earn in savings, checking or CD accounts each year. Paying taxes means you can't earn interest on the part of your previous interest that went to Uncle Sam - and you can't compound as quickly.
There are many fantastical stories about the power of compound interest. A favorite is if your great, great, great grandmother saved a dollar at the start of the American Revolution in a 6 percent savings account, you'd have over $830,000 today. She earned 6 percent on the first dollar to get $1.06, but then 6 percent on that whole amount to increase to $1.124, then to $1.19, $1.26, $1.34 ... it starts catching on quickly. But now let's assume each of your grandmothers from 1776 to 2010 had to pay 25 percent tax on the interest each year. Your $830,000 decreases to only $30,000. However, let's assume you don't plan on retiring in 234 years. Earning 6 percent on $10,000 over just 30 years results in $57,434 if you didn't have to pay tax on the interest each year, or $37,453 if you did.
Traditional IRAs and Roth IRAs both let you reap the benefits of higher compounding. The difference is when the taxes get paid. Uncle Sam is going to get his cut some time.
If you save within a Traditional IRA, your contributions may be tax deductible in the year you make them, depending on your income level. When you retire, you will pay income tax on the amount you withdraw each year. When you're age 70 1/2, you will be forced to withdraw a minimum amount just so they can start collecting the taxes. If you need to take an early withdrawal, you pay a 10 percent penalty in addition to the taxes due.
In a Roth IRA account, you do not get the tax deduction the year you make the contribution. However, all your withdrawals in retirement are tax free. Also, for direct contributions you can make early withdrawals of principal without tax or penalty. Rollovers and conversions have a five-year 'seasoning' period before you can make penalty-free withdrawals. Roth IRAs don't have the required minimum withdrawals after age 70 1/2, so they are an effective way to pass assets to your heirs if you don't need the money for your own retirement.
So what's the catch with the Roth? Many people have lower total incomes in retirement than during their working years, so perhaps you end up paying more in taxes now than you would in a Traditional IRA. If you plan on retiring to a state with lower state and local taxes, you would also be paying a larger amount of tax now. And finally, there are income limits for making a Roth contribution - $106,000 if single, $167,000 if married filing jointly. Roth contributions are essentially not allowed if married filing separately.
In any case, consult with your financial and tax professionals before converting from a Traditional IRA to a Roth or changing where you make your contributions. If done correctly, such a change can potentially make a big difference in your retirement plans.
Jason Gray owns GoalView Advisors, a Registered Investment Advisory firm in Falcon. He is a Falcon resident and serves as Chairman of the Board for the Eastern Plains Chamber of Commerce. He can be reached at 719-439-2054 or jason.gray@goalviewadvisors.com.
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Jason Gray