The Roth IRA is a type of retirement account and was born on January 1, 1998 as a result of the Taxpayer Relief Act of 1997. It was named after the late Senator William V. Roth, Jr. who was the sponsor of the bill that created this type of retirement account. It differs from a traditional IRA in several unique and specific ways.

First of all, unlike traditional IRS’s, not everyone can contribute to a Roth IRA. The IRS uses your modified adjusted gross income (MAGI) to determine if you are eligible to contribute to a Roth IRA. Basically the MAGI is your adjusted gross income (AGI), but with some modifications to the normal deductions. You typically won’t need to figure this number unless you are right up against the limits which are as follows for 2009:

• Married filing jointly or qualified widow(er): Up to $166,000 (to qualify for a full contribution); $166,000-$176,000 (to be eligible for a partial contribution); over $176,000 (you can’t contribute)
• Married filing separately (if the couple lived together for any part of the year): $0 (to qualify for a full contribution); $0-$10,000 (to be eligible for a partial contribution); over $10,000 (you can’t contribute)
• Single, head of household, or married filing separately and you did not live with your spouse at any time during the year: Up to $105,000 (to qualify for a full contribution); $105,000-$120,000 (to be eligible for a partial contribution); over $120,000 (you can’t contribute)

2010 limits are basically the same. The only change is for those who are married filing jointly whose limits are increased slightly as follows: Up to $167,000 (to qualify for a full contribution); $167,000-$177,000 (to be eligible for a partial contribution); over $177,000 (you can’t contribute).

If you are qualified to contribute to a Roth IRA then the full contribution for both 2009 and 2010 is $5000. If you are over 50 by the end of the tax year (December 31, 2009 for the 2009 tax year) then you are eligible for a catch up provision that allows you to contribute $6000 per year.

Why Should I Care About Roth IRA’s?

Because they’re good for you, well they’re good for your financial health anyway. You see, unlike a traditional IRA, SEP IRA and SIMPLE IRA the Roth IRA has one very distinctive tax benefit. The money you put in the Roth IRA is put in after taxes are paid on it. This means you can’t use contributions as a deduction on your tax return, but it also means that the government doesn’t tax the money when you withdraw it. Not any of it. This is huge because it means your money grows tax deferred AND you can use it during your retirement without paying any taxes.

Think of this scenario. Julie was money wise at an early age and began contributing to her Roth IRA when she was fresh out of college at 22 years old. She contributed the full amount every year and her money grew on average at 7% annually (Julie was a pretty conservative investor). After 37 ½ years of this Julie was ready to retire and enjoy the money she put away over the years. By only contributing $194,000 over the 37 ½ years, Julie would have a balance of $877,622. And ALL of that money could be withdrawn TAX FREE. Compare that to a similar investment made in a taxable account over that time which would have only grown to $577,145. Tax free compounding is pretty powerful stuff and when you combine it with tax free withdrawals it is like rocket fuel.

Consider this. A retire couple filing married with the standard deduction can make up to $19,050 a year without owing any taxes. If they can supplement this with $2000 monthly withdrawals from a Roth IRA they would have $3587.50 monthly with no tax liability. Not too shabby.

Another benefit of the Roth IRA is that you can withdraw any contributions both tax and penalty free. Makes sense since the money you put into the Roth has already been taxed. This makes the Roth a useful place to stick emergency funds or savings for longer term purchases as well. If you can only save $5000 a year ($10,000 for couples), why not put it into and account that grows tax free? The money will still be easily accessible and you’ll be avoiding any taxes on the interest or investment income. This is actually perfect for our needs right now. Golf and I want to save to buy a house once we’re living in Thailand. Unfortunately I cannot own land as a non-Thai citizen. It will take me a minimum of 8 years to become a citizen. This means we effectively have at least 10 years before we will be buying our house. By maxing out both of our Roth IRA’s we will have put aside $103,000 in 10 years time (I’m 43 currently so the catch up provision will be in effect for me for 3 of the 10 years). If we don’t have enough other savings we can pull that money out to complete our house purchase. And yes, that should be plenty to buy a nice 3-4 bedroom house in Thailand where housing costs are much lower than here in the U.S.

In addition, if you’re using the Roth IRA to save for a first home purchase you will want to know that you CAN make tax and penalty free withdrawals of not only your own contributions, but also the earnings in the Roth once it is held for 5 years. This is considered a qualified distribution and is both tax and penalty free. You can learn more about Roth IRA distribution rules from Ryan at CashMoneyLife.

And to make the Roth IRA even sweeter you can also use both the contributions and qualified earnings for your child’s college expenses. Craig at Money Help for Christians discusses the plusses and minuses of doing so and it is actually one of the alternatives that I am considering to fund our daughters’ education. Since we will be living abroad I have no idea what country she will be attending school in and the Roth IRA might provide me with the flexibility I need.

When you consider the tax advantages and flexibility of the Roth IRA I think it should be high on anyone’s list of retirement accounts to set up and start funding right away. It’s not difficult to do as most financial institutions offer a Roth IRA account. If you haven’t already opened an account check with your bank, broker or financial advisor to get one opened right away. Oh, if you open the account before April 15th 2010 you can still make the full $5000 contribution for your 2009 tax year.

Let’s face it, April 15th is either the most loved or most hated day of the year, depending on whether or not you’re getting a refund from the good old IRS. Personally I don’t care that much about the refund vs payment debate, I figure the government is getting their share either way. I hate it because of the extra work involved in pulling all your records together and trying to decipher some of the convoluted instructions for completing some of the forms. It’s a huge time suck and also usually serves to highlight what an infant I am when it comes to money. Here’s another blogger who hates the U.S. tax code with 9 things you can do to get ready for tax season. A bit late, but better than never.

This year actually had me hating it even more than usual, although I’ve since changed my opinion. The reason I was hating on tax day so much this year is because I owe the IRS a HUGE chunk of cash, thanks to my fair bit of success in running my own business this year. I didn’t mind the huge expense so much, in fact I had kind of anticipated it (well maybe not quite as much as it turned out to be) and thankfully have enough money put aside to pay for it. No, the reason I was hating it is because my underpayment was more than $1000 I now have to file quarterly estimated taxes for 2010.

Sigh…little did I know that under U.S. tax law the income tax is a “pay as you go” tax. This means that the government wants their share of your income as soon as you make it. If you underpay substantially they hit you with penalties and force you to file quarterly the following year (unless you’re willing to pay more penalties) in an effort to get your tax dollars out of you more quickly.

So, I was hating the idea of having to do taxes 4 times a year rather that the usual once, but then I realized that this is a perfect opportunity to take a deeper look at my tax situation, find ways to reduce my taxes and keep myself more organized throughout the year. I don’t know about all of you, but I am pitiful when it comes to keeping track of my income and expenses in regards to taxes. Of course this meant that every year I would be scrambling to find all the documents and receipts I needed to prepare my taxes. A healthy shot of organization is going to be very helpful, especially as my self employed business income and expenses grow.

Thus far I’ve taken the following steps to reduce the tax bite for 2010:

1. My wife is pregnant which means we will have an extra deduction for 2010. Not really planned, but it will help.
2. She will also be off work for 3 months and when she returns it will be on a part time basis. Mixed blessing as it also cuts into our cash flow, but we feel it’s best that one of us is always home with the baby. I know daycare is deductible, but we’d rather not have the expense to begin with and both of us firmly believe that the parents should be home with the baby.
3. I’ve increased my 401k with holding substantially. I’m still not at the full possible amount of $16,500, but getting there is one of my goals for 2010. Every dollar that goes into my 401k is a dollar I won’t be taxed on (yet). Because my wife isn’t a U.S. citizen we’re still trying to figure out how much she should be contributing to her 403b or if it’s even necessary aside from the current tax benefits.
4. I’ve committed myself to plowing 40-50% of gross earnings back into my business. As with the 401k I’m not quite there yet for January and February, mostly because of expenses for the baby. Added to that is the current need to pay off my remaining credit card balance. This is another goal I will have completed before the end of 2010 which will free up about $700 a month for more useful things than increasing Capital One’s profits. The upside here is that re-investing the earnings from the business will not only lower my tax bill, but should also drive more growth for the business, definitely win-win.

Obviously I haven’t had the dubious pleasure of doing my first estimated quarterly tax return, but it’s right around the corner. Both Golf (my wife) and I will receive our last paycheck for the first quarter on March 19th at which time I can start to work out what the first quarters payment will be. Oh, one other nice thing about paying quarterly is that I feel there’s a very good chance that I will actually get a refund next year instead of paying in as I normally do. As long as the refund is under $1000 I won’t feel too bad about giving the U.S. treasury an interest free loan, considering the current economic state of affairs in the U.S. they could probably use it. You can read a better explanation of why a tax refund is a horrible thing here.

Funny how as you grow up you learn to like the very thing you once hated and even begin to see the benefits of it. Kind of like learning to love broccoli and liver isn’t it?