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Secret Benefits of the Roth IRA

Updated on March 1, 2014
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Keith Schroeder writes The Wealthy Accountant blog with 30 years experience in the tax field. He is the tax adviser of Mr. Money Mustache.

The Roth IRA gained popularity from the moment it was signed into law August 5, 1997. The Roth IRA was available for tax year 1998 for the first time. Most people understand the Roth IRA grows tax-free. What most do not know is the Roth has several hidden benefits underused.

You can use the Roth IRA as an emergency fund, short-term investment plan, college saving program, vacation fund, or retirement. All these opportunities exist with tax-free growth.

In this article I will outline how you can withdraw from a Roth IRA at any age and never pay tax or penalty. I will show you why you should save even your short-term money in a Roth IRA and why college planning is easier with a Roth than any other traditional savings methods.

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Contributions

You are allowed a $5,000 contribution per year up to your earned income. A spouse with little or no earned income can also contribute the full deduction as long as their spouse has enough earned income. The year you reach age 50 and thereafter you are allowed an additional $1,000 annual contribution. Contributions are not deductible, but grow tax-free.

The Roth IRA has a contribution phase-out based on income. Once you reach the income threshold your maximum contribution is reduced. The charts below show the phase-out ranges.

Note: The phase-out only applies if you have another retirement plan. If your employer has no retirement plan, you are allowed a Roth IRA contribution at any income level.

2010 Roth IRA Contribution Phase-Out

Filing Status
Modified AGI Phase-Out Range
MFJ, Qualified Widower
$167,000-177,000
Single, HOH
$105,000-120,000
MFS*
$0-10,000
*Married individuals living apart the entire year are treated as single.

2011 Roth IRA Contribution Phase-Out

Filing Status
Modified AGI Phase-Out Range
MFJ, Qualified Widower
$169,000-179,000
Single, HOH
$107,000-122,000
MFS*
$0-10,000
*Married individuals living apart the entire year are treated as single.

Distributions

Distribution rules for the Roth IRA make all the difference. Distributions from a Roth are accounted for on a “first in, first out” basis. This means that your original investment is returned before any profits. All other retirement plans distribute profits first or pro-rata.

The accounting treatment of distributions allows tax and penalty free distributions of original contributions. This is a powerful planning tool. If you and your spouse contribute $5,000 each for 5 years, you are allowed a $50,000 tax and penalty free distribution regardless your age. Since it is not included in income, it will not bump your tax bracket higher either.

You are not allowed a contribution to a traditional IRA after you reach age 70 ½ even if you work and have earned income. The Roth allows a contribution at any age. The tax planning tools I outline next are available to everyone below the phase-out level with earned income.

Roth IRA

What Can a Roth IRA Do for You?

Planning Points

With basic knowledge on contributions and distributions listed above, there are several available tax planning tips. The following examples show how to save for each occasion.

Emergency Fund: You save $100 per month from your paycheck into your emergency fund. You contribute the money to a Roth IRA. In the event of an emergency, you distribute the needed funds, leaving all profits behind to avoid any tax or penalty. The profits grow tax-free and are available at age 59 ½ tax and penalty free. In 5 years you have $6,000 saved, plus profits. The $6,000 is available to you at any time without tax or penalty. The longer you go between emergencies, the more you have available for later use.

Vacation Fund: You plan a family trip to Europe. You need $10,000 to go. You save each month for 2 years using a Roth IRA. You can now take the $10,000 in contributions tax and penalty free. If you change your mind, the money is still available at any time for any other needs. The money continues to grow tax-free until distributed. Profits continue to grow tax-free for retirement.

College Fund: Every college savings plan has its disadvantages. The Roth IRA has solutions. You and your spouse each save $5,000 per year for several years for you child’s college expenses. Your combined Roth IRA nest egg has reached $100,000, plus profits. As your child reaches college age, she decides not to go to college, or, better yet, decides to go using the full scholarship she has earned.

Many college savings plans require someone to go to collage or monies invested face penalty. Imagine your joy from hearing your son or daughter earned a full scholarship only to sink back to Earth when your tax accountant explains your tax situation.

The Roth IRA solves the problem. If your child changes their mind or you feel they have not earned a free trip to college, you are under no obligation to distribute Roth IRA monies as other tax advantaged college savings plan require. Partial scholarships allow you to keep more money in your Roth for retirement. Flexibility is the key here. You choose how and when to pay for a child’s college expenses from a Roth.

Roth IRAs for Kids: There is no age limit to contributing to a Roth IRA. All earned income can get added to a Roth IRA (up to the contribution limit), even if the child is not required to file a tax return. An allowance for work performed around the home by a minor child qualifies for a Roth contribution. Income earned by a minor child from the parent is only subject to income tax, not self employment or payroll taxes. Young children rarely earn enough to file a tax return. A child can add $400 of allowance (as an example, not a limit) to her Roth IRA over the year. If they need money for personal purchases, they distribute the money tax and penalty free. Earnings grow tax-free. What an easy way for your children to start saving for retirement pain free.

Retirement Fund: The Roth IRA is a retirement fund with added benefits. You can still use the Roth as a retirement funding vehicle. The contributions are available at any time for any thing, including early retirement.

Since the Roth IRA grows tax-free, your goal is to contribute as much as possible for as long as possible to gain the maximum benefit of tax-free growth.

If you never used a Roth IRA before, consider setting one up now. The Roth is a solid financial planning tool. You contributions are always available without tax consequences. The Roth is a painless way to build a retirement account even if you have no funds to save for retirement. The profits keep growing tax-free while your money is invested and available when you need it.

Suze Orman on Roth IRAs

Comments

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    • Jlbowden profile image

      James Bowden 

      6 years ago from Long Island, New York

      KT:

      Awesome information about the Roth IRA tax advantages. You certainly answered many formerly unanswered questions about a ROTH that I had. And I believe you did just as good of a job, or not better than Suzie O. My company over the past few years has given us the option to contribute a percentage of our gross salary to a Roth, and we can also contribute an even percentage to the original 401K that the company has been doing for us all along. I am know beginning to wonder if I should be putting all of my salary contributions into just the Roth alone, instead of splitting it between both 401K and Roth equally? Voted useful as well as Up! JLbowden

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