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The Roth IRA and Why (Most of) You Need One Yesterday

October 6th, 2011 by 
PK

It's a topic we've covered here at DQYDJ before, and we'll definitely do it again in the future. Every once and a while everyone needs a reminder: if you qualify, start a Roth IRA today. If you have one and you aren't funding it: do it.  Here's a rehashing of why!

One Reason to Start a Roth IRA: Tax Diversification

Most people reading this (traffic spikes during working hours!) are likely at a corporate job, something with a 401(k).  401(k)s are great, and you should definitely contribute, at a minimum, enough to get your company

Start a Roth IRA Today?  Shuffleboard tomorrow.

Start a Roth IRA Now... Worry-Free Shuffleboard Later! (Christopher Dick)

matchNot all companies currently offer a Roth 401(k), which is treated much the same as a Roth IRA.  Roth based retirement plans allow taxes to be paid up front as you deposit money into the account, never to be paid again.  Traditional plans, like many 401(k)s people have been contributing to for a while, allow tax free deposits while taxing withdrawals on the back end.

The practical implication of the difference?  Roth IRAs (and 401(k)s) are a bet that your taxes will be higher when you withdraw the money.  This may be because you moved into a higher tax bracket, or simply because tax rates increased.  Traditional 401(k)s and IRAs are a bet that your tax rate will be lower when you take out the money.  By having both types of accounts you can hedge your bets, taking out money from your traditional accounts in years your rate will be lower, and the Roth accounts when it will be higher.

Pay Yourself First!

The 2011 Tax Year IRA Contribution limit is $5,000, and $6,000 if you age 50+.  Double those numbers if you have a spouse - so $12,000 if you are both 50+, $11,000 if just one of you is north of 50, and $10,000 for the rest of the married couples.

The IRS limits who can contribute to a Roth IRA.  In 2011, as a couple, you must make less than $177,000 or $120,000 as a single filer to make a partial contribution.  Full contributions are available under $169,000 as a married couple filing jointly and $105,000 as a single filer.  These numbers are modified adjusted gross income, so if you are close you might be able to take enough deductions to fit under the limit.  If you can't quite make it, it's possible you can roll over a traditional IRA.  See the IRS publication for that information.

I put sort of a throwaway phrase at the top of the section- pay yourself first.  What do I mean by that?

Simple, really.  Invest in the Roth before the money hits your bank account and can be spent.  Just as a 401(k) is a paycheck deduction, it's almost like you won't miss the money if you automatically divert it to your Roth IRA.  It's late in the year now, but it's easy to calculate.  Just figure out how many times a year you get paid - twice a month would be 24, every other week 26 and weekly 52, for example- and divide $5,000 by that number (adjust for the limits listed above).  So:

$192.30 a paycheck if you are paid every two weeks, $208.33 if you are paid twice a month, and $96.15 if you are paid every week.

Either direct deposit that to your IRA or set up an automatic pull from your bank account after you know the paycheck will be there.  Automatic investing works!

More IRS-Sheltered Money

This topic is last, but only because it's a more advanced strategy.  Roth accounts actually allow you to shield more of your money from the drag of taxes than traditional accounts can offer.  How do I figure?  Both accounts offer the same exact contribution limits - for a single, under 50 filer, $5,000 for either IRA and $15,500 for either 401(k).  But note, things are not equal.  From that $5,000 or $15,500 in a tradional account, you will eventually need to pay taxes.  This is a tricky enough concept it deserves a whole other article (and note I'm assuming all the money is pulled out at the marginal rate), but it stems from the fact that you are paying all of the Roth taxes up front.  By this argument a Roth (either IRA or 401(k)) is superior even if your marginal tax rate is exactly the same in retirement.  Don't let me glaze over this point though; if you are confused, email or comment!

Conclusion

If you qualify for a Roth IRA (I know it's an if!), definitely consider opening one or tossing money into your existing account.  And consult a financial adviser if you have specific questions about your finances.  That said, general questions and strategy descriptions are free game in the comments.  Fire away!

Now go start a Roth IRA and come back and tell us how painless it was!

Don't Quit Your Day Job...

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