What Congress Has "Roth"

Written and edited by Harry Rubins for his clients and friends.
Not intended as legal or tax advice.
Obtain professional advice before taking action on this information.

The Roth IRA… is a great way to save for a down-payment on a house or children’s education while you are saving for your own retirement.

Wow!  The Roth IRA that Congress passed in 1987 is potentially the most significant legislation designed to stimulate savings since the original IRA was introduced in the 70’s.

Author of the bill and Senate Finance Committee Chairman, William Roth (R-Delaware), presented the legislation under the title “IRA Plus Accounts”.  House and Senate conferees changed the name to “Roth IRA: to honor him for his long-time advocacy of tax-free retirement accounts.  How refreshing to hear that not all politicians have big egos! Senator Roth died in 2003.

The Roth IRA, like a Traditional IRA, allows you to invest up to $3,000 plus $500 for anyone age 50 by December 31^st each year into a tax-advantaged retirement account.  Sorry, you can’t do $3,000 in each type of IRA, only $3,000 total between the two.

To make a contribution, you or your spouse must earn at least $3,000 at work ($6,000 to include non-working spouse) or in profits from self-employment.  No tax deduction is allowed on contributions made to a Roth IRA.

However – and this is the really good stuff – think of the Roth IRA as a mirror image of a Traditional IRA.  Rather than the upfront tax savings on the deposit offered with the Traditional IRA, the Roth IRA allows you to save taxes at the other end.  Withdrawals are tax-free when you meet a few simple requirements.  The advantage over many decades is enormous because you won’t pay taxes on the account growth.

Contributory Roth IRA Advantages

Key Benefits

• Tax-free growth and withdrawals of earnings

            -After age 59 ½
            -Account opened at least 5 tax-years

• Withdrawal of contributions at any time

            -No penalty, no taxes
            -Even before age 59 ½

• No requirement to begin taking Required Minimum Distributions

Avoids being forced to take age 70 ½ distributions. You control when to take  distributions, not the IRS.              

Other Advantages

• Continue contributions after age 70 ½, if you or your spouse still work
• Active participant rules don’t apply for Roth IRA because they are non-deductible
• Roth IRAs are available to many wage earners  with a high AGI for maximum contribution.

            -Single AGI up to $95,000 with phase out to $110,000
            -Joint AGI up to $150,000 with phase out to $160,000

• Estate planning is simplified

            -Heirs receive accounts income tax-free (federal estate tax still due)
            -Can fund credit shelter trust

• Penalty-free withdrawals of earnings before age 59 ½ (same as a Traditional IRA)

            -First-time home purchase
            -Post secondary educational expenses

One of the most significant advantages of a Roth IRA over a Traditional IRA is that contributions can be withdrawn at any time tax-free and penalty-free even before the age of 59 ½.  The order of withdrawals is that contributions come out first, then earnings.  It is the earnings inside the Roth IRA that are subject to taxes and penalties.  Roth Conversion accounts have different rules and penalties on withdrawals so they need to be kept separate from Contributory Roth IRA accounts.

To withdraw earnings without penalty and tax assessments, you need to be over age 59 ½ and have established your Roth IRA for at least five tax years.  There are two special exceptions for withdrawals before age 59 ½.

• First-time home purchase – up to $10,000 life-time
• Post secondary education expenses – up to 100% of qualified expenses per year

The early withdrawal penalty is waived on earnings for both types of special withdrawals but the earnings are treated differently for income taxes.  Withdrawals of earnings for educational expenses are taxable, whereas withdrawals for a first-time home purchase are tax-free.

A 1998 Roth IRA contribution made by April1 5, 1999, would be open less than five calendar years, but would meet the five tax-year holding period on January 1, 2003.  Subsequent annual Roth IRA contributions are governed by the establishment of the original Roth IRA.  Contributions made after the original account is open five tax- years have no holding period.

The Roth IRA advantage of being able to withdraw contributions without paying taxes and penalties at any time before age 59 ½ is a double-edged sword.  It is a great way to save for a down-payment on a house or children’s education, however you can short-change your retirement nest egg with frequent withdrawals.  Remember, the annual limit on contributions would prevent you from redepositing a $10,000 withdrawal in one lump sum. 

Which IRA is better for you?  The Traditional or Roth?  Either one is great, so just do it!  If a tax deduction motivates you or if you have limited funds, the Traditional tax-deductible IRA costs less.  At the 28% tax rate your out-of-pocket cost if $1,440 because you get back $560 in taxes when you make a $2,000 deposit.

On the other hand, if you can easily afford to contribute $2,000 after tax, make it a Roth IRA.  The biggest mistake is doing nothing.