FOOL'S SCHOOL DAILY Q&A

Roth IRA ABCs
Understand the power of the Roth IRA

	Email this page Format for printing Reuse/Reprint
	Related Links 60-Second Guide to Opening an IRA Tax Strategies IRS website The Motley Fool Tax Guide 2002
	Discussion Boards Discuss This Column Ask a Foolish Question Tax Strategies

By Selena Maranjian (TMF Selena)
August 8, 2002

Q. How do Roth IRAs work, and should I use them?

A. Many hail the Roth IRA as the greatest tax break ever invented, but there are some important issues to consider before jumping on board.

Like other IRAs, the Roth allows you to accumulate funds for retirement and to enjoy some tax advantages at the same time. While contributions to a traditional IRA are tax-deductible (if you're eligible), contributions to a Roth IRA are not. However, traditional IRAs are tax-deferred, which means you don't pay taxes on the annual growth, but you do pay ordinary income taxes on the distributions in retirement. This is a good deal, but for many investors, the Roth is better because the growth and distributions are completely tax-free.

Let's say you're 35 years old and you invest $3,000 of your post-tax income into a Roth IRA each year, starting today. You earn a 10% annual return for the next 30 years until you retire at 65. By then, your contributions would have grown to about $500,000. With a Roth, that's your take-home pay. With a regular IRA, you would pay taxes on any withdrawals, netting just $420,000 or so, assuming a 15% tax bracket during retirement, or merely $365,000 if you are in a 27% bracket.

So far, this is very convincing. But remember that if the $3,000 had gone directly into a traditional IRA, you would have reaped about $810 in tax savings each year if you were in the 27% bracket (and possibly more than $1,000 each year if your tax bracket is higher). If that savings is also invested, the total difference between the Roth and the regular IRA becomes slimmer.

There are other aspects of the Roth that make it a very compelling proposition:

• Assets in a traditional IRA must start being distributed by the time the account owner turns age 70 1/2, whether the money is needed or not. Thus, the account owner loses the benefit of tax deferral on that money, and the withdrawals may move her to a higher tax bracket. However, there is no required distribution age for assets in a Roth IRA. If the money is not needed, it can continue to bask in the glow of tax-free growth.
• Withdrawals from a traditional IRA before the account owner is age 59 1/2 results in immediate taxation and a 10% penalty. On the other hand, contributions to a Roth IRA may be withdrawn anytime, penalty- and tax-free. The same can be said of earnings withdrawn for first-time home purchases as long as the money has been in the account for at least five tax years. Not that we recommend this, but if you need the money, it's there.

The Roth is fully available to individuals who earn up to a certain amount. You can roll over, or convert, your traditional IRA into a Roth by paying taxes on it, counting the entire value of the account as income.

There are more benefits and limitations to consider before you decide whether the Roth is for you. You can get details from your local tax professional, from the IRS website, and also at the Fool's Tax Strategies and Retirement areas. Also, check out our book, The Motley Fool Tax Guide 2002, which is a surprisingly readable and even amusing tax reference book.

If you decide a Roth IRA is for you, visit our 60-second guide to opening an account.

If you have any questions, thoughts or opinions on this column, share them with others on our discussion board for Ask the Fool.

This question and answer is adapted from The Motley Fool Money Guide: Answers to Your Questions About Saving, Spending and Investing. For answers to this and 499 other common money questions, check it out -- it's a handy resource.