Rising popularity of Roth IRA as retirement vehicle

csims@tri-statedefender.com | 11/16/2011, 6 p.m.
Sims Jr.

Roth IRAs are quickly catching up to their older counterpart, the traditional IRA. About 19.5 million U.S. households owned Roth IRAs in 2010, compared with 38.5 million households who owned traditional IRAs. But the Roth IRA has been in existence only since 1998, while the traditional IRA has been around since 1974.

What’s fueling the growth of this retirement vehicle? Americans may be attracted not only by the tax advantages offered by the Roth IRA, but by the flexibility it may offer.

Consider the trade-offs

Taxes: The main difference between a Roth IRA and a traditional IRA is that Roth IRA contributions are made with after-tax dollars, whereas contributions to a traditional IRA may be tax deductible. The difference when you withdraw your money, however, is that qualified distributions from a Roth IRA are free of federal income tax if you’ve satisfied the requirements. By contrast, distributions from a traditional IRA are taxed as ordinary income. (Roth IRA distributions may be subject to state income taxes.)

Eligibility: Anyone under the age of 70½ with earned income is eligible to contribute to a traditional IRA. There are no age limitations associated with a Roth IRA, although you must have earned income in order to contribute.

Income eligibility restrictions are associated with both types of IRAs. Eligibility to contribute to a Roth IRA phases out at higher modified adjusted gross income levels: $107,000 to $122,000 for single filers and $169,000 to $179,000 for married couples filing jointly in 2011. Although there are no income limits to contribute to a traditional IRA, investors who are active participants in employer-sponsored retirement plans cannot deduct their contributions if their modified AGIs exceed $66,000 for single filers or $110,000 for joint filers.

Contribution limits: There is a $5,000 annual contribution limit to all IRAs combined in 2011. Investors age 50 and older may make an additional $1,000 catch-up contribution.

RMDs: Traditional IRAs are subject to annual required minimum distributions (RMDs) that must begin after you’ve reached age 70½ (the first distribution must be taken no later than April 1 of the year after you turn 70½). However, no RMD rules apply to Roth IRAs. Thus, if you don’t need the money, you can leave Roth IRA assets to your heirs, who can also benefit from tax-free distributions. Failing to take an RMD may result in a 50% tax penalty on the required amount that was not withdrawn. Beneficiaries of either type of IRA are required to take RMDs (based on their own life expectancies).

Withdrawal considerations: Withdrawals from either type of IRA prior to age 59½ may be subject to a 10 percent federal income tax penalty. Exceptions to the penalty include the owner’s death, disability, and a qualified first-time home purchase ($10,000 lifetime maximum). Regular Roth IRA contributions (not earnings) can be withdrawn at any time for any reason without any tax liability or penalty. For a tax-free and penalty-free withdrawal of earnings, qualified Roth IRA distributions must meet the five-year holding requirement and take place after age 59½.

If you are looking for a way to help manage your income tax liability in retirement and possibly leave a tax-free legacy to your heirs, you may want to consider a Roth IRA.

(Charles Sims Jr., CFP, is President/CEO of The Sims Financial Group. Contact him at 901-682-2410 or visit www.SimsFinancialGroup.com. The information in this article is not intended to be tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor.)