There is a new IRA called the Roth IRA. (From this point on, it will simply be referred to as Roth.) The Roth is almost the exact opposite of the traditional IRA. With the Roth, your contributions are not tax deductible. However, when you withdraw the money in retirement, you do not pay any income tax. At face value, this seems too good to be true. In reality, it is a good deal for most people, but it is important to understand why it is a good deal.
Before you get too excited, you must understand that after all the taxes have been paid, both types of IRAs produce identical returns. To illustrate, let’s say you get a $2,000 bonus at work and you wanted to invest it in an IRA. With the traditional IRA, you don’t pay any taxes on the money before you invest it, so you can invest the whole $2,000. With the Roth, you first have to pay income tax (28%) on that bonus money, which leaves you with only $1,440 to invest. After 20 years of 10% annual growth, the traditional IRA would have grown to $13,455. After paying the 28% income tax, you are left with $9,688. With the Roth, your $1,440 grows to $9,688 (tax-free). As you can see, the returns are identical. This holds true regardless of the number of years or the annual interest rate. The bottom line is basically an issue of when you pay your taxes, now or later.
Here’s another way of looking at this issue. As we saw, the traditional IRA and the Roth both generated the same amount of money. However, if we put $2,000 in the Roth, instead of $1,440 (as described in the scenario above) you will end up with $13,455 instead of $9,688. Since the maximum amount you can put into any IRA is $2,000 a year, the Roth gives you the ability to set aside more money for retirement. Therefore, if you have enough surplus money to meet the IRA’s limit, the Roth is for you.
I have saved the best for last. Many people (which includes most of the middle class) don’t qualify for the traditional IRA tax break. Therefore, there’s no incentive for them to use the traditional IRA. They still can invest $2,000 a year into an IRA, but they just can’t deduct it from their taxes. So, instead of putting money into IRAs, these people would put their extra money into normal investments, such as stocks or mutual funds. Of course, they have to pay taxes on the profits. For these people, the recently enacted Roth becomes a way to invest up to $4,000 a year and not pay taxes on the profit. You may be wondering where I came up with $4,000. The husband can make a $2,000 contribution and so can the wife.
Any of the following items will disqualify a couple from getting a tax break on the traditional IRA:
The basic rules for the Roth is you must hold it for at least five years and be 59 ½ before you start collecting it. Even if you don’t meet these qualifications, you can still withdraw your contributions (not the growth) at any time, tax-free and penalty free. In the previous illustration, I used the example of earning 10% a year. In reality, your IRA’s earnings are dependent upon the aggressiveness of your investments. Most IRAs offer the same investment choices as the 401(k).
It is important to understand that I have not provided all of the rules that apply to IRAs. I have only covered the main ones that most commonly affect the middle class. As with all other investing, you should carefully read the rules and talk to a financial planner.
There’s also a new way to save for your kid’s college bill. It is called the Educational IRA (a misnomer, since this IRA has nothing to do with retirement). Basically, you can contribute up to $500 a year into each of your children’s account (until they turn 18). Like the Roth, you pay taxes on the money before you put it into the IRA and you don’t pay taxes on the profit when you take it out. Of course, you have the same investment options as the other IRAs. Fortunately, contributions to the Educational IRA will not count against the IRAs yearly limit of $2,000.
If the money is used for any qualified educational expenses, you pay no income tax. It can be used to pay for tuition, books, supplies, and certain room-and-board expenses. The term "qualified" usually means the schools have to be accredited. As a result, most Bible schools do not qualify. If you have any doubts about whether a school is qualified, you should contact the school and your financial advisor.
Your child does not have to go to college right out of high school. He has up to the age of 30 to use the money in this IRA. If you need to, you can roll part or all of one Educational IRA into the Educational IRA of your other child. If you decide to use this money for something other than education, you will have to pay normal income tax plus a 10% penalty.
In my opinion, this is a long overdue tax reform. However, at present, it is uncertain if the educational IRA will hurt your child’s chances for financial aid. Of course, many middle class families don’t qualify for financial aid anyhow.
Although it is not as financially attractive, you can now use your traditional IRA to pay for qualified educational expenses. Until recently, you had to pay a 10% penalty if you withdrew money for your child’s educational expenses (if you were under 59 ½). Although it is now penalty free, you still have to pay normal income tax. In everything I’ve read, most financial advisors still discourage using the traditional IRA for educational expenses.
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