What Can a Roth IRA Do for You?

What with all of the recent tax changes, it seems that the Roth IRA has been forgotten by a number of taxpayers. That's a shame, because the Roth IRA offers a number of advantages other than a retirement savings account.

Roth IRAs are tax-favored accounts to which qualified taxpayers can make after-tax (i.e., nondeductible) contributions. Contributions to the account can grow tax-free, and neither the contributions nor the earnings on them are subject to tax when a Roth IRA owner receives a qualified distribution from the account. Although a Roth IRA is designed to help taxpayers save for retirement, it is completely false to view a Roth IRA as only a retirement savings vehicle. A Roth IRA can offer tax, estate planning, and financial planning advantages that are not available with respect to a traditional IRA.

Roth IRAs offer several advantages over traditional IRAs.

First, an individual can make contributions to a Roth IRA regardless of age. A person who has reached age 70 1/2 by the end of the year cannot make contributions to a traditional IRA.

Second, distributions can be made completely tax-free, as long as they are qualified distributions. In general terms, qualified distributions are distributions made more than five years after the contribution and that are taken after the owner has turned age 59 1/2, died, or become disabled, and distributions for certain special purposes, including the purchase of a first home. With a traditional IRA, distributions are fully taxable, except to the extent they represent the return of after-tax contributions.

Third, the owner is not required to take minimum required distributions (i.e., forced distributions after the owner turns age 70 1/2), so the tax-free buildup can continue throughout the owner's life.

Fourth, distributions of Roth IRA contributions are always tax-free, no matter when they are taken.

A taxpayer deciding to take lifetime distributions can benefit from the favorable tax treatment accorded to Roth IRAs. Like traditional IRAs, Roth IRAs provide for tax deferral on the earnings. However, since no tax is imposed on a Roth IRA distribution, as long as that distribution is qualified, this benefit is increased. Because tax-free distributions of earnings can occur only after the five-year requirement is satisfied, to take full advantage of this (as well as to maximize the amount of earnings on which tax is deferred), contributions to a Roth IRA should be made as soon as possible. In fact, parents or grandparents may want to consider setting up and funding a Roth IRA for their children or grandchildren as soon as the children or grandchildren have enough earned income from part-time or summer jobs. This will ensure that the five-year requirement is met when the individual for whom the Roth IRA is established is ready to make a withdrawal to buy a home, for example.

The fact that the owner is not required to take distributions makes Roth IRAs very useful as estate planning tools if the owner doesn't need the funds in the account. This is because the owner can leave the account intact for his heirs, thereby maximizing the tax-free growth of the account. In other words, by not taking distributions from the account, the Roth IRA owner, upon his death, will pass on a larger amount to his heirs than if the individual had been required to take distributions from the account. In addition, a beneficiary of a Roth IRA is permitted to take distributions from the account over a period not exceeding the beneficiary's life expectancy, so the tax deferral can continue after the original Roth IRA owner's death if the beneficiary does not need the funds immediately (and the Roth IRA owner can maximize this strategy by naming a young beneficiary). Finally, the distributions are tax-free when received by the beneficiary.

The fact that the taxpayer can withdraw the annual contributions made to a Roth IRA at any time without incurring any tax means that these accounts can serve financial planning goals that can't be served by a traditional IRA. Before making a contribution to a traditional IRA (or other retirement plan), it's generally important to be sure that you can afford to be without the funds for some period of time, since tax and heavy penalties are imposed when amounts are withdrawn. But that's not the case with a Roth IRA. With a Roth IRA, withdrawals before the five-year requirement are tax-free as long as they consist only of contributions. In addition, the tax on early withdrawals is imposed only to the extent that the withdrawal is included in income.

That means if you contribute $3,000 (generally, the maximum allowable for the 2004 tax year) to a Roth IRA, and one week later withdraw $1,000 from the Roth IRA, the withdrawal is not subject to tax. As a result, a Roth IRA can act as an emergency fund since you can make withdrawals from the account to the extent of the contributions as they are made to the Roth IRA account. In effect, you've created a tax-deferred emergency fund.

For example, assume a taxpayer contributes $2,000 to a Roth IRA in 2002, 2003, and 2004. In October 2005, when the account is worth $8,000 (contributions plus earnings), the taxpayer sustains hail damage to his roof that isn't covered by insurance. The taxpayer needs $5,000 to repair the damage. Since the taxpayer made contributions to the Roth IRA equal to $6,000, the taxpayer can withdraw $5,000 tax-free from the Roth IRA to pay for the damage. In applying this rule, distributions from a Roth IRA are treated as coming from contributions first.

Because of this nontax treatment on contribution distributions, it's imperative that you keep accurate records of the contributions you make to a Roth IRA. That's because if a withdrawal is made from the account, you can show that the withdrawal is coming from contributions and is, therefore, tax-free.

As you can see, Roth IRAs can be a very important component of not only your retirement plan but also your overall financial plan. Don't overlook all of the advantages that Roth IRAs have to offer.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.