Too many taxpayers fail to take advantage of Roth IRAs. That's a shame, because the Roth is far more than an ordinary retirement savings account.
Roth IRAs are tax-favored accounts to which qualified taxpayers can make non-deductible, after-tax contributions. Those contributions can grow tax-free, and neither they nor the earnings they generate are subject to tax if withdrawn as a qualified distribution.
Although the Roth IRA is designed to help taxpayers save for retirement, it can also offer tax, estate-planning, and financial-planning advantages unavailable with a traditional IRA:
- There's no age limit to contributions to a Roth IRA. A person who has reached age 70 1/2 by the end of the year cannot make contributions to a traditional IRA.
- Qualified distributions from a Roth IRA are completely tax-free. To qualify, distributions must be made more than five years after the contribution and taken after the owner has turned age 59 1/2, died, or become disabled.
Distributions are also available for certain special purposes, including the purchase of a first home. With a traditional IRA, distributions are fully taxable, except to the extent that they represent the return of after-tax contributions.
- Unlike owners of traditional IRAs, a Roth IRA owner is not required to begin taking distributions from the account at age 70 1/2. The tax-free accumulation can continue throughout the owner's life.
- Distributions of Roth IRA contributions -- money the owner personally put into the Roth IRA, as opposed to the additional earnings generated by those 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-deferred earnings. However, the benefit is greater because no tax is imposed on a qualified Roth IRA distribution.
Because earnings distributions become tax-free only after the five-year requirement is satisfied, the sooner you contribute to a Roth IRA, the more you can save on taxes -- and earn on returns. Adults may want to consider setting up and funding a Roth IRA for their children or grandchildren as soon as those kids have enough earned income from part-time or summer jobs. That way, the five-year requirement can be satisfied by the time the person for whom the Roth IRA is established is ready to make a withdrawal -- to buy a home, for example.
The lack of minimum required distributions makes Roth IRAs very useful as estate-planning tools, assuming the owner doesn't need the funds in the account. The owner can leave the account intact for his or her heirs and thereby maximize its tax-free growth. If the owner doesn't take distributions from the account, his or her heirs will receive a larger amount.
In addition, beneficiaries of a Roth IRA can take completely tax-free distributions from the account throughout their entire lives. And if a beneficiary doesn't need the funds immediately, that money can keep growing tax-free for years to come. The Roth IRA owner can maximize this strategy by naming a young beneficiary.
Taxpayers' ability to withdraw annual contributions to a Roth IRA tax-free at any time means that these accounts can serve as financial-planning goals in a way no traditional IRA could. Before making a contribution to a traditional IRA or other retirement plan, taxpayers must make sure they can afford to do without the funds for some period of time; early withdrawals bring taxes and heavy penalties.
But that's not the case with a Roth IRA, in which 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.
Suppose you contribute your $4,000 annual lump sum to a Roth IRA. That's the maximum allowable amount for tax year 2007; taxpayers 50 or older can also contribute an additional $1,000 in catch-up funds. One week later, you withdraw $1,000. That withdrawal is not subject to tax. In this way, the Roth IRA can act as a tax-deferred emergency fund -- provided that you withdraw no more than you've contributed.
Another example: Suppose you contributed $2,000 each year to a Roth IRA in 2004, 2005, and 2006. In October 2007, when the account's total contributions and earnings are worth $8,000, your roof sustains $5,000 in hail damage, and your insurance won't cover the cost. Because you contributed a total of $6,000 to your Roth IRA over the years, you can withdraw the $5,000 you need, tax-free, to pay for the damage. (When applying this rule, distributions from a Roth IRA are assumed to have come from contributions first.)
You must keep accurate records of the amounts you do contribute to a Roth IRA. If you make a withdrawal from the account, you'll then be able to show it came from contributions and is therefore tax-free.
Roth IRAs can be a very important component of your retirement plan and your overall financial plan. Your most Foolish strategy, of course, is to avoid taking early distributions from your Roth IRA whenever possible, to allow the greatest amount of money to grow and compound tax-free over the longest possible time. Nonetheless, you shouldn't overlook the many other advantages that these IRA instruments have to offer.
This article was originally published on Aug. 4, 2006. It has been updated.
When he's not dealing with tax issues, Fool contributor Roy Lewis is a motivational speaker who lives in a trailer down by the river. 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.