If You Don't Have One... Get One

June 24th, 2009 by 

If you saw $1,377.71 lying on the ground, would you pick it up?  That's about the amount an average person could save in taxes just by opening a Roth IRA... and funding it.

I hope you would.  That's the sort of savings you could find from opening a Roth IRA.  Any increase in your future tax rates means you made money simply from choosing the right account to invest in.  Sound good?  Read the article.

How Does a Roth IRA Work?

IRAs and 401(k)s both allow you to hedge against future taxes.  While 401(k)s are only available through an employer, IRAs are completely self-directed.  Like the 401(k), IRAs have both a Roth and a traditional option.  The Roth option means you pay tax on your income now, with no additional taxes when you eventually withdraw it.  In the traditional IRA, you pay no taxes upfront, but pay when you withdraw your funds.  In essence, you bet your tax will increase with the Roth and decrease with the traditional.

What's the Eligibility for a Roth?

For a Roth IRA, the following applies.  Currently, a person filing single can contribute with a modified adjusted gross income of $101,000, with a partial contribution up to an income of $116,000.  If a person is married filing jointly, a full contribution is up to $159,000 with a partial contribution up to $169,000.

Contribution is up to a maximum of $5,000 per year (Ed: thanks Melissa!) for people under 50 and $6,000 per year for people above 50.  You can contribute up to your income (if you earn $4,900, you can contribute $4,900).  If you are married filing jointly, your spouse may open an account and contribute regardless of whether he or she earns income.  Finally, you may open an account for a minor and fund it up to their taxable income.

Additionally, starting in 2010 there will be no income limit when converting traditional IRAs to Roth IRAs.  Read more here.  You can even use the conversion process to try to eliminate some of those taxes.  Whew.  Them's the rules.

Now to the Roth IRA Math

Opening a Roth IRA versus displaing cash on hardwood

Opening a Roth IRA is better than storing your cash on the floor...

How did I get $1,377.71?  That's an easy one- it's the difference in what you would pay in taxes to get $5,000 under two different tax rates.  Specifically:

When Joe Sixpack first contributes to his Roth IRA, he  lives in California, paying 25% in federal tax and 9.55% in California tax.

Joe requires ($5,000 / (100% - 25% - 9.55%) =) $7639.42 in earned income to fill his IRA to the max.

When he retires, and is able to take his money out, he is pulling out the equivalent of $373,000 in today's money (good work Joe!).  How is that $5,000 treated?  As a tax free withdrawal.  What would it cost Joe in income to get that $5,000 now?  He pays 35% in federal tax and 9.55% in California tax.  He would need to earn ($5,000 / (100% - 35% - 9.55%) =) $9,017.13 to save enough.

There you go, $1,377.71 in savings. If you can assume your income tax rate will increase in the future, you will save money with a Roth IRA. With the massive increase in the federal deficit, (and the inherent promise to pay it back in the future) now is the time to hedge against taxes.

Next Steps for Opening a Roth IRA

Your possibilities are pretty limitless with a Roth IRA in terms of account structure.  Banks and mutual fund companies have IRAs.  Brokerage companies do too.  You can even invest in real estate in yours.  The step you take next isn't important, but it's an important step.  If you haven't yet opened an IRA of some sort and are eligible.... do it now.



PK started DQYDJ in 2009 to research and discuss finance and investing and help answer financial questions. He's expanded DQYDJ to build visualizations, calculators, and interactive tools.

PK is in his mid-30s and lives in New Hampshire with his wife, kids, and dog.

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