One of the best retirement saving tools still is not sufficiently understood or employed.
The Roth IRA, created in 1997, is utilized by just 16 percent of U.S. households. If more people grasped the benefits, that number would be much higher.
Roth IRAs are fundamentally different than traditional IRA accounts (which usually hold pretax assets). Contributions to a Roth are after-tax transactions and therefore not deductible.
However, the investment gains earned on these after-tax contributions are exempt from income taxation, as long as the first contribution is held at least five years, and the account owner is at least 59-1/2 years old. This is an important distinction: not tax-deferred, but totally tax-free.
And not just tax-free to you, but to your heirs as well. Unlike a traditional IRA, there is no required minimum distribution with a Roth, so you can continue to contribute as long as you have income, and pass the assets along to your heirs with no income tax liability.
Contributions are limited to a maximum of $5,000 per year or the amount of earned income, whichever is less. Spouses with no earned income still may make contributions if the other spouse has sufficient income. There is also a catch-up provision which allows individuals age 50 or over to contribute an extra $1,000 each year.
Obviously, the Roth IRA is most attractive to those who have many years to allow the magic of compounding to magnify their tax-free gains. Nevertheless, it is sometimes challenging for younger savers to commit to traditional retirement contributions early in their working lives.
With the Roth IRA, contributions (but not earnings) are available to withdraw without penalty or taxation at any time. While this is not preferable in terms of building a retirement nest egg, it provides younger investors the opportunity to start salting away a few bucks knowing they can access the money under exigent circumstances. Just starting an emergency fund? Think about doing it with a Roth.
To illustrate the power of this vehicle, consider a 25-year-old who begins a Roth IRA today with the maximum $5,000 contribution and continues funding at that rate each year until age 70. At a relatively modest return of 6 percent per year, our future millionaire puts in $230,000 and walks away with $902,500 in tax-free investment gains to keep, spend or leave to the kids. Left untouched at the same rate of return, the account value exceeds $2 million at age 80.
Traditional IRAs may be converted to Roth accounts by declaring the amount converted as income and paying the taxes. This may be an interesting option for more mature account holders in low tax brackets who wish to create a tax-free legacy for heirs or escape the required minimum distribution requirement. You may convert any portion of an IRA and may spread conversions over several years.
Given the uncertainty regarding future tax rates, starting a Roth IRA is one of the smartest steps you can take outside of your 401(k).
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA is a vice president at Barnett & Co. Submit questions to his attention by writing Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga TN 37401-1447, or by emailing him at email@example.com.