Understanding The Roth IRA
I love the Roth IRA and often recommend opening one to people who qualify. To contribute the maximum in 2013, a married couple filing taxes jointly needs adjusted gross income under $178,000.
Here is why I like Roth IRA’s:
1. Tax diversification: Most of us have heard about the need to diversify our investments but what about the need to diversify our retirement income? When you contribute to tax-deferred accounts like 401(k)’s or a Regular IRA’s, you lower your taxable income at the time of your contribution and agree to pay tax later in retirement. With a Roth IRA, you contribute after-tax money now (so you get no tax benefit today) but the money is tax-free in retirement if you follow the rules. It’s hard to predict if you will be better off paying tax now with the Roth IRA or paying tax later with your Regular IRA or 401(k) but why not hedge your bets and do both?
2. Avoid Required Minimum Distributions (RMD’s): When you reach age 70 1/2 the IRS will require you to take a certain amount of money out of your tax-deferred accounts each and every year and pay tax on it whether you want to or not. With a Roth IRA there is no Required Minimum Distribution so you can take money out (or not) on your own timetable – not the governments!
2. Emergency Savings: You can withdraw your original contributions to a Roth IRA at any time for any reason with no questions asked or penalties or taxes to pay. I like the idea of having access to my money if I need it. The account acts as emergency savings if I ever need it and tax-free retirement money if I don’t.
3. Investment Freedom: For people with horrible company retirement plans (meaning no index funds offered and high overall costs) opening a Roth IRA at a place like Vanguard, Schwab or Fidelity will give you a lot more investment freedom and ability to keep costs low.
One note of caution: A friend recently told me that they tried to open a Roth IRA at three different financial institutions and the sales people at each told her that she could not withdraw any money including her original contributions for 5-years without paying a penalty. This is wrong! You do need the account to be open 5-years for the earnings and interest to be considered tax-free but you can always withdraw your original contributions at any time.
My friend then called Vanguard and confirmed my information but think about all the people who got bad advice and just gave up. Don’t be one of them!