Roth IRA’s for Infants
As you read yesterday, one of my personal finance goals for 2010 is to fully fund a Roth IRA for both myself and my wife. A nice stretch goal would be to also fund our daughters Roth IRA fully, but I don’t expect that will happen. Maybe you’re smiling and saying “Good goals”, however some of you may be knitting your brows wondering what the heck is a Roth IRA?
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.