Roth IRA accounts have been available since 1997. In a traditional IRA, you contribute pretax dollars that grow tax deferred, but are taxable upon withdrawal. Roth IRAs are for after tax contributions that provide tax free growth and distributions upon retirement.
The magic of compounding means, the earlier you start, the greater the tax-free growth within the account. If you are 20 when you start making contributions, you could be looking at four doubles of your original contribution by the time you retire at age 60. That means a $5,500 contribution this year could grow to $88,000, allowing you to potentially create $82,500 of tax free income for your retirement years.
Another reason to open a Roth IRA is the flexibility it can provide to fund emergencies that may arise over your lifetime.
The Five-Year Rule
You can always withdraw any Roth IRA contributions without taxes, after all, you paid income tax on the money prior to making the contribution. However, if you haven’t had the Roth IRA open for at least five years, your distribution could still be subject to a 10% tax penalty, similar to the early withdrawal penalty for traditional IRAs.
The five years for withdrawals begins when you open the account, not when you make subsequent contributions. There is also a five-year rule for Roth IRA conversions that start in January of the year you make a conversion. This additional rule was enacted to prevent someone from using a Roth IRA conversion to avoid early distribution penalties from traditional IRA withdrawals.
Who qualifies for a Roth IRA
If you have a modified adjusted gross income of less than $116,000 and are single or less than $183,000 if married filing jointly, you can make Roth IRA contributions of 100% of your income up to $5,500 if younger than age 50 or $6,500 if age 50 or older.
Back-door Roth IRAs
Because there are no income limitations for converting traditional IRAs to a Roth IRA, many who are disqualified for income resort to the back-door method for funding a Roth IRA. This works because anyone may open and contribute to a non-deductible traditional IRA, even if you are covered by a qualified retirement plan.
Once the funds are deposited into the nondeductible traditional IRA, they can then be converted to a Roth IRA. This has the same net income tax effect as contributing directly to a Roth IRA.
The Early Bird Gets the Worm
Tax free growth and tax free distributions are very enticing especially for those with many years until retirement, so start today. The more time your account has to grow tax free, the better.
Assets can transfer to your heirs in one of two ways when you die. They can transfer by will, which includes probate court and public filing of related documents, or they can transfer by contract.
The advantages of having your assets transfer by contract include:
Examples of assets that transfer by contract include accounts or assets titled Joint Tenants with Right of Survivorship, Transfer on Death and Pay on Death accounts, Life Insurance and Annuity contracts, Trusts, and your IRA and 401k accounts if you complete the beneficiary forms correctly.
When you first establish an IRA or 401k, an annuity or life insurance contract, you are provided a form to name beneficiaries. If you fail to complete these forms the assets will usually pass back into your estate and become part of the probate process. By naming a beneficiary or beneficiaries you can let these assets transfer by contract. You should also name contingent beneficiaries and choose whether you want the assets to transfer per stirpes or per capita. By filling out these beneficiary forms you are insuring that your wishes are honored after your death.
Many people name only a spouse as a beneficiary. If the couple have children or grand children they wish to provide for they should consider making them contingent beneficiaries to preserve the tax benefits of an IRA (however if the children or grandchildren are minors be sure a guardian has been named or the funds will be encumbered until the courts name a guardian).
Currently only surviving spouses can transfer assets from their deceased spouse's 401k to their own IRA, but the recently enacted Pension Protection Act of 2006 will extend that privilege to any beneficiary after 2007.
The bottom line is beneficiary forms are an integral and important part of your estate plan. Choosing the right way to transfer these assets can save time and money, but can also be confusing. If you are unsure how to proceed choose a professional to help you, but don't delay.