The Roth IRA Rules!

If you're going through life assuming that there isn't much difference between a traditional IRA and a Roth IRA, you're doing yourself a great disservice -- because the Roth IRA rules.

Roth IRAs and traditional IRAs have some key differences, and offer different benefits. With a traditional IRA, you enjoy tax deferral. If, for example, you make the maximum contribution of $5,500 for 2013 (it's $6,500 for those 50 or older), you'll be able to deduct that sum from your income on your 2013 tax return. So if you would have paid a 25% tax rate on that $5,500, you're saving $1,375 -- now. There is a catch, of course. When it comes time to withdraw money from your traditional IRA, your withdrawals will be taxable, at your income-tax rate at the time. (Remember that in retirement, many people are in lower tax brackets.)

Roth IRA rules
With the Roth, you contribute money that is not tax-deferred. Your contribution does not lower your taxable income. Here's the benefit, though: When you withdraw funds from your Roth IRA in retirement, they're tax-free! Your money grows tax-free. There are some other advantages, too, such as not having to take required minimum distributions once you turn 70 1/2, as is required by traditional IRAs. (There are still Roth rules to observe, though, such as, in most cases, not withdrawing funds before age 59 1/2 or before you’ve had the account for five years, if you want to avoid a penalty.)

The Roth's tax-free status can be a big deal, especially if you make the most of it by loading it up with certain types of investments. Fast-growing companies, for example, are ideal. If they double, triple, or increase tenfold over your holding period, all that gain will be tax-free in the Roth. Think of Amazon.com (NASDAQ: AMZN  ) , which sports an average annual growth rate of more than 27% over the past 15 years. It's almost always considered overvalued, yet it has kept growing. That growth could stop or slow one of these days, but bulls remain hopeful. Some worry about the company having to collect sales tax as governments level the playing field to help brick-and-mortar retailers -- but even that cloud has a silver lining, possibly leading to more distribution centers for Amazon. Amazon stock has grown more than ninefold over the past decade, turning a $10,000 investment into more than $90,000. If you had held the stock in a Roth and withdrew it per the Roth IRA rules, that $80,000 gain would be tax-free!

Companies that stand a good chance of surging in coming years are also good Roth candidates. Exelixis (NASDAQ: EXEL  ) , for example, is a smallish biotech company tackling various cancers. It even has an approved thyroid cancer drug on the market, and the formula may end up approved to treat other conditions, as well. The downside, though, is that the drug is expensive, and the segment of thyroid-cancer patients who might take it is very small.

Beaten-down companies that you think are likely to recover strongly are also good candidates. Molybdenum miner Thompson Creek Metals (NYSE: TC  ) , for example, sports average annual losses of 35% over the past five years, and carries substantial debt, but molybdenum's long-term outlook is promising, with price increases likely, and the company has a promising gold and copper mine on track to start producing by the end of the year. Freeport-McMoRan Copper & Gold (NYSE: FCX  ) is another major molybdenum player, with considerable operations in other metals, as well -- along with new investments in oil and gas production.

Dividend stocks, too, are great candidates, as dividends are typically taxed at ordinary income tax rates, and in a Roth would accumulate tax-free. Intel (NASDAQ: INTC  ) , for example, recently yielded 4%, and though its recent earnings report was disappointing, it expects profit-margin improvements and is making inroads into the booming mobile market.

Learn the rules
It's important to read up on all the Roth IRA rules and traditional IRA rules, and considerations related to both, before you decide between them. For example, if you expect your tax rate to be significantly higher in retirement, a traditional IRA will seem less attractive. And if you only have $5,000 to contribute toward retirement and your employer will match some or much of that in your 401(k), then perhaps an IRA isn't your best bet.

Keep in mind, too, that tax rules do change over time. Some people are wary because they fear that the appealing Roth IRA rules might be changed in the future. Others think it unlikely that Congress will wipe out the benefits of the Roth for those who have been investing with it and counting on it.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 24, 2013, at 12:36 PM, dbtuner wrote:

    "When you withdraw funds from your Roth IRA in retirement, they're tax-free!" As of the rules of today. Who knows what rules there will be tomorrow. They could limit your SS based on how much you have in your IRA. They could institute a tax on "excessive" IRA's. Who knows?

    I would rather take a sure thing deduction now than hope for one later on.

  • Report this Comment On April 24, 2013, at 12:59 PM, highgamma wrote:

    I agree with dbtuner that what I call "renege" risk is high in Roth IRAs. That's why I limit Roth's to less than 30% of my tax preferenced accounts. However, Roths give a lot of flexibility to save on taxes if the government tries to renege on its promises. I can take the money out of the Roth before I start collecting Social Security (for instance) if there is a rule change. Roths can be emptied without a tax hit before an "excessive" IRA tax is imposed while traditional IRAs cannot so easily be emptied.

    More importantly, I can fund Roth IRAs in years where my tax rate is low and fund traditional IRAs in years where my tax rate is high. (My income is quite variable.) This is an enormous benefit to Roth IRAs. There's also some tax diversification benefit from having both accounts. I just don't want to get carried away.

  • Report this Comment On April 24, 2013, at 2:43 PM, TheTourist90 wrote:

    From a pure taxable income point of view where all things being equal, there is no difference between a Roth IRA and Traditional IRA. For Example:

    Assumptions:

    Tax Rate 28%

    Rate of Return 6%

    Initial Investment: 10000

    20 years until retirement

    Traditional IRA

    10000 * 1.06 ^ 20 = 32071.35 * (1 - 0.28) = $23091.37

    Roth IRA

    10000 * (1 - 0.28) = 7200 * 1.06 ^ 20 = 23091.37

    So the factors that someone should consider when determining whether to contribute to a Roth or Traditional IRA are:

    1) What will your tax rate be when you retire. If your tax rate will be lower when you retire, chose traditional. If it will be higher, choose Roth.

    2) When will you take Social Security plays a factor. If you plan on taking social security before the full retirement age, withdrawals from a traditional IRA are used when calculating the earned income cap; whereas, Roth withdrawals are not.

    3) There is no minimum withdrawals for Roth as opposed to Traditional.

    4) Traditional IRA can allow for better tax planning. For example, there are AGI caps for certain tax credits like Child Tax Credit, Educational Credits, etc. A traditional IRA may allow you tax take full advantage of these credits thus lowering your effective tax rate now as opposed to when you retire when you may not qualify for the credits.

    So to say one is better than the other is a matter for each individual to determine. Also, these same considerations are true for Traditional 401Ks vs Roth 401Ks where contribution limits are higher.

  • Report this Comment On April 24, 2013, at 9:59 PM, herky46q wrote:

    Traditional IRA all the way.

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