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The Roth: An Amazing Opportunity

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For more than 10 years, a unique investment vehicle has given some people the chance to accumulate huge amounts of wealth. But until January of this year, many others didn't have access to what may prove to be the most important investing tool you'll ever find.

That tool is the Roth IRA, and although the name suggests that the Roth is primarily a method to invest for your retirement, it is flexible enough to serve a number of other purposes as well. From giving you a way to save for shorter-term goals to protecting your assets for future generations to come, the Roth IRA is so valuable that you won't want to miss out on the chance to use it in your own financial planning.

Let's take a closer look at exactly what the Roth can do for you -- and why it's getting so much attention right now.

What makes Roths great
Right now, it's hard to remember when financial innovation didn't automatically conjure up feelings of skepticism and distrust. But back in the late 1990s, when the Roth IRA was first created, it ushered in a new way to think about saving for retirement.

Until then, retirement investing was all about tax deferral. Traditional IRAs and 401(k) plans allowed savers to set money aside for the future, giving many of them a current tax break on their contributions. In other words, the government essentially paid you back for part of what you put into a retirement account in the form of a tax deduction. Depending on your tax bracket, that deduction could be extremely valuable as a current benefit, irrespective of whether saving for retirement was your primary goal.

The trade-off, though, was that when you actually used the money, you had to pay taxes on what you took out. From one perspective, then, the U.S. government shared in your investment gains and losses. If your IRA skyrocketed in value, then the IRS would collect more tax. Just look at some of these examples:

If You Invested $2,000 in an IRA 20 Years Ago in This Stock

It's Now Worth This Much

And the IRS Could Collect up to This Much in Taxes

Microsoft

$117,231

$41,031

Home Depot

$37,090

$12,981

United Technologies

$31,266

$10,943

ConocoPhillips

$15,564

$5,441

Apple

$47,948

$16,782

Nordstrom

$10,129

$3,545

Amgen

$101,018

$35,356

Source: Yahoo! Finance. Assumes taxpayer is in top current tax bracket of 35%. Prices from January 1990 to January 2010.

Those tax figures represent a darn good return for the U.S. Treasury, especially when you consider that the upfront deduction on the original $2,000 only cost them $660 or less in tax revenue.

The Roth IRA turned that logic on its end. Rather than giving you a current incentive to save, the Roth pushed the incentive far into the future by making all the growth within your account tax-free. And if you decide to convert an existing traditional IRA into a Roth, then it's even more obvious that the Roth is a different animal than traditional retirement accounts -- because you have to pay tax on the amount you convert.

Opening the door
Until now, though, many investors have been locked out of the Roth IRA. Income limitations prevent many high-income investors from using a Roth IRA, either through annual contributions or by converting existing IRAs to Roths.

Now, though, those income limits on Roth conversions have disappeared. And although high-income earners may still not be able to make their $5,000 annual contribution to a Roth, anyone who has a traditional IRA can choose to convert now.

So the big thing that everyone's asking right now is this: Should you convert to a Roth? That turns out to be a much more complicated question than you might think, but I've attempted to get after that answer for Fools:

Get Dan Caplinger's columns every Monday and Wednesday on Fool.com!

Fool contributor Dan Caplinger made his first Roth IRA contribution in 1998 and has never looked back. He doesn't own shares of the companies mentioned in this article. This is an updated version of a column first published Jan. 4, 2010. Home Depot and Microsoft are Motley Fool Inside Value selections. Apple is a Motley Fool Stock Advisor recommendation. Motley Fool Options has recommended a diagonal call strategy on Microsoft. The Fool's disclosure policy is always on the lookout for big things.


Read/Post Comments (12) | Recommend This Article (9)

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 March 17, 2010, at 7:32 PM, FinnMcCoolIRA wrote:

    Definitely!

    Also, keep in mind that in addition to the pending higher Obama income tax rates on all IRA withdrawals (much higher than the 'deferral' received when funding the IRA), we will also be 'double taxed' on almost all of our Social Security benefits -- again, at the higher rates.

    What a scam!

    Roth's are often a good way to go!

  • Report this Comment On March 18, 2010, at 3:56 AM, PoundMutt wrote:

    How long do you think the radical left wingers of the Obama Administration and his allies in the Dumbocratic party will allow us to have UNTAXED ROTHs!!!???

  • Report this Comment On March 18, 2010, at 9:29 AM, DJDynamicNC wrote:

    @PoundMutt - it's probably not worth pointing out facts to somebody who would use a term like "Dumbocratic party," but you should know from reading the article directly above here that your comment is allegedly related to that the Roth is an expressly middle and lower class investment vehicle. Although higher income citizens can rollover traditional IRAs into a Roth, they are progressively restricted from utilizing it as a standard investment vehicle. And the maximum input each year is just $5,000, hardly a rich man's trophy.

    Now, does that really sound like something Obama, who cut middle-class taxes while seeking to allow the Bush tax cuts on the wealthy to expire, would want to curtail?

    On the other hand, I suppose calling somebody a radical left winger and then yelling at them for regressive tax policies is about as consistent as I'd expect from you.

    Enjoy your new health care! :)

  • Report this Comment On March 18, 2010, at 9:37 AM, DJDynamicNC wrote:

    At any rate, I came back to this article to ask a bit of advice. I currently have a 401(k) offered through my employer. It is NOT matched, though the investments offered are quite good.

    I just opened a Roth IRA yesterday and am about to begin filling it.

    My question is, should I max out my Roth and just leave the excess for the 401(k), or should I focus on my 401(k) and just toss a small amount (or none) towards the Roth? I don't currently make enough to max out both - I've only just completed the first year of my career.

  • Report this Comment On March 18, 2010, at 11:52 AM, edyboom223 wrote:

    I would say that if you enjoy investing and have a discount broker to max out the roth first. It probably gives you more freedom and costs less $ when done right. Good luck!

  • Report this Comment On March 18, 2010, at 1:31 PM, DJDynamicNC wrote:

    Thanks! I think you're right, I'm using Sharebuilder and they had a promotion running which allows me to invest in a Roth IRA for the rest of this year for free, so that's definitely where I'm heading then.

    Cheers!

  • Report this Comment On March 18, 2010, at 1:45 PM, switchingtoguns wrote:

    DJ,

    My suggestion, or rather my opinion, would be to max out the contributions to your Roth IRA first and then whatever is left put into your 401(k). Since there is no match for your 401(k) you are not missing out on any automatic gains, just your tax deferral. As with any investing advice, it really comes down to what your individual circumstances are.

    The biggest benefit of the Roth is that you have already paid taxes on the money but it is also worth noting that you have flexibility with you money as well should you have an emergency prior to turning 59 1/2:

    The rules for penalty-free, tax-free distributions from a Roth IRA account are fairly complex. First, some terminology: a Roth account is built from contributions (made annually in cash) and conversions (from a traditional IRA); earnings are any amounts in the account beyond what was contributed or converted. The rule are as follows:

    Contributions can be withdrawn tax-free and penalty-free at any time (unlike your 401k or traditional IRA)

    There is 5-year timeframe that starts on the first day of the first tax year in which any Roth IRA is opened and funded.

    Earnings can be withdrawn tax-free and penalty-free after 5 years AND a qualifying event occurs

    The early withdrawal penalty does not apply to distributions that:

    the participant reachs 59 1/2 years of age

    Occur because of the IRA owner's disability. (IRS Code Section 72(m)(7) and IRS Publication 590. defines what qualifies)

    Occur because of the IRA owner's death.

    Are used to pay for unreimbursed medical expenses that exceed 7 1/2% of adjusted gross income (AGI).

    Are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for more than 12 weeks.

    Are used to pay the costs of a first-time home purchase (subject to a lifetime limit of $10,000).

    Are used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members.

    Are used to pay back taxes because of an Internal Revenue Service levy placed against the IRA.

    The order of withdrawals (distributions) has been established to help investors. When a withdrawal is made, it is deemed to come from contributions first. After all contributions have been withdrawn, subsequent withdrawals are considered to come from conversions (if you converted a traditional IRA to a Roth IRA). After all conversions have been withdrawn, then withdrawals come from earnings.

    Since a penalty may apply only to the withdrawal of EARNINGS on contributions or conversions, it's important to understand the ordering rules that apply to Roth IRA distributions. The ordering rule is simply the method used by the IRS to determine what portion of the Roth IRA is actually being removed from the account first.

    According to the IRS, the order of a distribution from a Roth IRA is:

    Regular Contributions - by considering the first money withdrawn from the account "regular contributions," and not earnings, the IRS allows account holders to remove a portion of their accounts before the five-year rule applies.

    Conversions - this is on a first-in, first-out basis. So the money placed into an account because of a conversion that occurred in 2008 would be removed before a conversion that occurred in 2009.

    Taxable - the taxable portion of the conversion is removed first. This is the amount claimed as income because of the conversion.

    Non-Taxable - this is the portion of the conversion not included in gross income.

    Earnings - finally, the last money to be removed from an account are the earnings on the assets placed in the account.

    The ordering for withdrawals allows taxpayers to remove money that has already been taxed before removing taxable money. This is both a logical and generous process for taxpayers since this ordering helps to minimize the chances an account holder takes a non-qualified, taxable distribution.

    OTOH, Here is the advantage of a 401(k):

    Pre-tax contributions (401k and traditional IRA's) allow you have a higher dollar amount in contributions because the tax is not taken out, but deferred until you start withdrawing money. Over time if you have a higher dollar amount (contribution) compounding interest - because the feds and state didnt get their taxes yet - it is possible that even though you pay the taxes in the end you are still way ahead because you had more money compounding that interest then if you had invested with after tax funds through a Roth.

    If I am not mistaken, the reason you see alot of retirees in Florida is because they have no state income tax thus their withdrawals from a 401k just get zapped by the feds but not by the state

    The drawback: The 401k will be taxed at an marginal tax rate once you begin taking withdrawals (who knows what that tax rate will be when you are eligible for withdrawals at 59 1/2 yrs old).

    Just my opinion but I like the idea that I have already paid my taxes on the Roth and will know the tax rate, 0%, when I decide to start withdrawing versus my 401(k) where the tax rate, which many posters on this site concede, will have to be higher in the future to pay for entitlements such as health care and SS and our need to service our nation's massive debt.

    Heres a good Fool artice on the matter:

    http://www.fool.com/personal-finance/retirement/2007/05/10/d...

  • Report this Comment On March 18, 2010, at 2:09 PM, ease1 wrote:

    @ DJDynamicNC

    I asked the local panhandler next to my office how his Roth was doing in this marker. He asked me what a Roth was. You should know that he probably makes a couple grand a week standing in that spot. What is classsified as lower class these days and what percentage of "lower class" do you know that actively contribute to a roth?

    Secondly - you propose in your statment that based on some logical sense of historical events (logical to you I suppose), that you can predict what Obama might do or might be thinking. That defies all laws of rational thinking and deductive logic. Who has ever been able to predict or count on for that matter what a politian might do? They are irrational power loving hores. BO has already shown that his words are empty. Don't forget the saying "power corrupts and absolute power corrupts absolutely". If our wonderful leaders on the capital could find a way to raid the Roth without sparking their demise, they will. It's just too tempting.

    Finally - regarding your question of 401 vs Roth, since the Roth is tax free (for now), it would seem to make more sense to max it out first and any left over goes to your 401. That's just my thoughts, you might have different circumstances. You might need to weigh the potential of high tax rates at retirement versus the ability to contribute more to your 401 over time since the maximums are different. If your employer ever began matching, then I would reverse the order.

  • Report this Comment On March 18, 2010, at 3:19 PM, DJDynamicNC wrote:

    @SwitcingToGuns - that was extremely informative. Thank you! I'm definitely following through on the Roth IRA at the expense of the 401(k). The Roth is much more flexible and tax free on the outside rather than at the outset, and you're right, I like the feeling of having my taxes out of the way. And at my current income (~25k) my taxes are fairly low.

    @Ease1 - First: the plural of anecdote is not data. Your example, further, is irrelevant - my point was not who is using a Roth, but to whom it is targeted. Do you really think an investment vehicle with an annual cap of $5,000 and a maximum income cap of around 100k is targeted at the upper class? Come on now. You're clearly a sharp person. Be reasonable.

    Second: OK, I'll give you that one. lol: I am not able to predict what Obama does, any more than I could predict that the person I voted for in 2000 as the best one to manage our surplus would run up the debt in massive interventionist conflicts. None the less, Obama has thus far proven to be a friend of the middle and lower classes, and anyone interested in re-enacting Glass-Steagal is probably NOT interested in shodding off the Roth IRA. But again, as you say, politicians are hard to predict, so no, I have no way of guaranteeing that. Fair point.

    Finally: Thanks! It seems like there's a strong consensus. I'm definitely going for the Roth.

    Cheers!

  • Report this Comment On March 18, 2010, at 4:14 PM, PoundMutt wrote:

    @ DJDynamicNC

    I am 71 and don't expect to have MUCH if ANY AFFORDABLE healthcare thanks to the fact that such a large percentage of healthcare costs are for the old folks and MUCH of BHOs cost savings MUST come from the denial of care to the elderly.

    Also, WHERE will the doctors, nurses and other medical professionals come from to treat the extra 30 million uninsured added to the rolls? Who in their right mind would go into approx $200,000 of debt to become a doctor in light of the cuts in payments for medical care?

  • Report this Comment On March 18, 2010, at 4:40 PM, cordwood wrote:

    Well DJ,your degrading remarks re POUND MUTTs terminollogy labels you as being a bit touchy re critiscism of your chosen heroe[s]. Perhaps describing them as Progressacrats might meet meet w/ your approval...if not TS.

    "Progressive" politicians,[regardless of Party], are always searching for a money fix and that's why I ,and POUND MUTT,are dubious about the future of tax deferred plans.

    "Enjoy your healthcare" ? ! How smug! How descriptive of your political bent!

  • Report this Comment On March 19, 2010, at 2:57 PM, DJDynamicNC wrote:

    @PoundMutt

    You're exactly right about the concern for health care cuts, which is why we wanted a true Medicare-For-All system from the outset. A Medicare buy-in, such as that proposed by Congressman Grayson, would allow those who wish to purchase Medicare coverage to do so (again that's PURCHASE, not simply receive), insuring both increased income and spreading the risk pool, generating lower premiums. In fact, given the efficiencies of scale generated by larger risk pools for insurance providers, a national Medicare system that covers everyone could be dramatically cheaper. I suppose we'll never know.

    That said, it should be understood that currently obscene industry profits ALREADY come from denial of care to the elderly - and everyone else, besides. What we're seeking to do is cut those profits, not cut the care. Will it work perfectly? Of course not. Medicare for all would have been much more effective. Seems a shame that we can't have socialized health care, because it would have done a much better job of protecting your... socialized health care.

    As for the doctor problem - agreed, there is a shortage of healthcare professionals (though plenty of high paying specialists). But you must consider that the wages we pay our doctors are dramatically higher than what they are paid in countries like Canada and England - countries which, you will notice, still have doctors who still save lives, and do it well. The solution is unlikely to be higher pay for doctors - what we need is to redefine the method in which we assign payment. Reimbursing doctors for procedures encourages extra and unnecessary procedures. That needs to be addressed. Again, Medicare for all would help with this situation much more effectively than the current bill.

    Fair points, which I feel would be best addressed by Medicare for all. As you know, Medicare works quite well compared to the alternatives.

    @ Cordwood - :lol: Touche my friend! Not a bad shot. I found the bit about Progressives "regardless of party" particularly entertaining. Progressive Republicans! Now that would be a trip. :lol: But you're quite right, my post was fairly smug and that's rarely conducive to solving problems. Well called.

    Cheers!

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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