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.