Financial Freedom Blog

This article, originally written in May 2005, is republished with minor editions. 

One of the greatest financial planning tools our benevolent representatives in Washington have ever granted us is the Roth IRA. (Half sarcasm, half sincerity)

The Roth IRA allows after-tax money to grow tax free. (Remember an IRA does not refer to the investment—it refers to the tax treatment. You can have all kinds of savings and investments inside your IRAs. Also remember, IRS eligibility requirements apply. You also must have earned income to contribute and higher income levels can limit your contributions.)

With a Roth, there are no Required Minimum Distributions (RMDs) at age 70.5 as with traditional IRAs.

Also, consider the tremendous tax-free wealth building potential for your heirs by “stretching” the Roth.

Having a bucket of tax free money in retirement can also give you some control over your taxable income when you are drawing from your assets in retirement. This could make a significant difference in the amount you are taxed on social security  income.

Why wait until April of next year to make this year’s contribution? Invest early in January and get a 15.5 month tax-free advantage. If you do this every year, the compound growth on the tax savings can be significant.

April 15, 2008 is the deadline for funding a Roth IRA for 2007. I believe the Roth IRA is one of the most under-used retirement vehicles available. It is so powerful, yet so few take full advantage of it. Let me address some misconceptions.

Misconception 1. A Roth IRA is invested a certain way. Truth: People ask me sometimes “How is a Roth IRA invested?” The answer is, “Anyway you want” (based on the investment options offered by your IRA custodian). In other words, you can be as cautious or aggressive as you like. The Roth IRA speaks of the tax-treatment—not the investment. After-tax money goes in. The gains and principle come out tax-free (assuming you’re 59.5 and have held the IRA 5 years).

Misconception 2. Roth IRAs are for young people. Truth: If you’re older, but still have earned income, why wouldn’t you want to enjoy tax-free gains versus taxable gains? The ability to cherry-pick your withdrawals from tax-free accounts as well as tax-deferred accounts can give you greater tax control during your harvesting years.      

Misconception 3. My Roth contributions cannot make a big difference in my retirement. Truth: The contribution allowance is now $4000 for those under age 50 and $5000 for ages 50 and older. Double that, and an older couple can contribute $10,000 in one year. That can add up over time.

Misconception 4. If you contribute to a 401(k), you cannot contribute to a Roth IRA. Truth: The amount you contribute to your 401(k) does not limit your contribution to your Roth IRA. Many people would actually be better off getting the company match on their 401(k), and contributing to a Roth next, assuming they cannot save enough to max out both. 

Misconception 5. The Roth IRA ties up your money. Truth: The principle from a contributory Roth IRA can be withdrawn for any reason, any time (before 5 years has passed), with no taxes or penalty. 

Many advisors will not stress the benefits of Roth IRAs with their clients because they don’t want the paperwork hassle of opening small accounts. But that’s no reason for you to miss out. I can open an IRA account for you in about 15 minutes—traditional or Roth—by phone or in person. 

1. Shelter up to 25% of your pay (up to $45,000) from 2007 taxes using a SEP IRA if you are a small business owner or self employed. The 2007 deadline is April 15th, 2008.

2. Deduct up to $5000 per person if you’re at least 50 years old ($4000 under age 50) for 2007, using a traditional IRA. 2008 contributions can also be made now. Limits for 2008 have increased to $6000 if you’re at least 50 years old–$5000 under age 50. The deadline for 2007 contributions is April 15th, 2008.