Pioneered by the late Senator William V. Roth, Jr., the Roth IRA came into existence on January 1, 1998 thanks to the Taxpayer Relief Act of 2007. The Roth IRA is unique from all the other retirement accounts because all the earnings you accumulate on your savings will grow tax-free when you withdraw them upon retirement. The only catch to this is that when you make the initial Roth IRA contributions, you will receive no deductions on your income tax return. Other benefits of the Roth IRA include the elimination of the minimum required distributions rule when you turn 70 and 1/2 years old (more on this below).
By making after-tax contributions to your Roth IRA, you will not owe a single dime of tax to Uncle Sam when you retire and withdraw your money. This adds the advantage of being able to grow your earnings tax-free not for the government, but for yourself! Which retirement plan is therefore the right choice for you? Well it depends on your personal situation. If you expect to be in a higher tax bracket when you retire, it is better off to pay the taxes right now and grow your savings tax-free in a Roth IRA. Because a Roth IRA holds after-tax dollars, you can maximize your contributions by adding greater tax leverage to your retirement savings.
Consider Jackson who earns a $65,000 annual salary. Jackson is currently in the 25% tax bracket and contributes $3500 a month to his Roth IRA. Jackson would therefore pay income taxes of $3500 x 25% = $875 and would contribute $3500 – $875 = $2625 to his Roth IRA. If Jackson expects to be in a 33% tax bracket upon retirement, he will have to pay $3500 x 33% = $1155 upon his retirement. Therefore by making after-tax Roth IRA contributions now and getting taxed at the lower 25%, Jackson avoids having to pay taxes @ 33% when he hits retirement.
Establishing a Roth IRA
A Roth IRA can be established by setting up your account and making a regular after-tax contribution to it. A traditional IRA can also be converted to a Roth IRA. What’s more, a Roth IRA can also be set up if you already have an employer sponsored 401k plan. This means you can make 100% of the total matching contributions that your employer makes to your 401k + contribute some more to the Roth IRA. This provides greater tax leverage and maximizes your contributions and returns in the long term. The maximum you can contribute to a Roth IRA for 2008 is $5000 ($6000 if you are 50 or older). In order to qualify for this contribution, your modified adjusted gross income (MAGI) cannot exceed $101,000 for Singles and $159,000 for married couples filing joint returns. See the table below for a complete list of Roth IRA contribution limits.
Note: You can convert your traditional IRA to a Roth IRA only if a) your modified adjusted gross income (MAGI) does not exceed $100,000 and b) you’re filing single or joint with your spouse.