If the recent decline in your retirement plan savings accounts isn’t enough to keep you up at night, try the following:
Income tax rates are likely to go higher while you’re working, and remain there during your retirement. Social Security will be there for you in some form, but a good portion of that will be subject to those aforementioned taxes.
The simple solution to these problems is to just save more money for retirement. But that’s easier written than done, especially if you’re already maxing out your retirement contributions, or are concerned that you might need some of that money in an emergency.
Here’s how a Roth IRA can defeat your retirement nightmares in one swoop—without necessarily locking up you money until you’re (even) older and grayer.
Background
As you may know, for the 2008 tax year full Roth IRA contributions can be made by anybody with earned income, and whose adjusted gross income is under $159,000 for married couples filing jointly ($101,000 for singles).
The maximum contribution is the lesser of your earnings, or $5,000 ($6,000 if you’re over 50). Spouses without earned income can make similar contributions based on their partners’ earnings.
There is no immediate tax deduction on deposits to Roth IRAs. But future earnings in the account are sheltered from taxes, and then withdrawals taken after age 59_ are tax free.
What you didn’t know (or perhaps forgot)
In return for foregoing an upfront tax break, you receive a nifty benefit when using a Roth IRA: all contributions can be withdrawn at any time, for any reason, with no taxes or penalties whatsoever.
The good people at the IRS let you designate your withdrawal as the “contribution” portion of the account, until you’ve used up the amount you’ve deposited.
So if want to save for retirement, but are worried that you might need that money before you turn 59 1/2, you can take comfort in knowing that a large portion of your Roth IRA can be withdrawn at a moment’s notice, and with no taxes or penalties.
Or, the Roth IRA can do double-duty saving for both retirement and college. If your retirement accounts are more than fully-funded when your kid graduates from high school, the contribution portion of the Roth IRA can be used to pay for higher education—again, free from penalties and taxes.
No taxes on Social Security
Social Security payments received in retirement are ostensibly tax-free. That is, unless you receive just a modest amount from other sources like interest, earnings, or IRA withdrawals (see www.ssa.gov for the figures).
Then either 50% or 85% of your Social Security income is taxable, and at your highest rate. But Roth IRA withdrawals are one of the few sources of income that aren’t counted when determining if your Social Security payments are taxable.
So a retiree can theoretically pull a million dollars out of his Roth IRA in a single year, and as long as he has no other income other than Social Security, his federal tax bill will be zero.
You decide when to take the money
The IRS requires you to begin withdrawing (and paying taxes on) money from your IRA after you turn 70 1/2, and the percentage required to be withdrawn rises for as long as you live.
But Roth IRAs have no mandatory distribution age. So not only will you avoid taxes on any withdrawals, but you can take the money out when it suits you best—if you take it out at all.
Act now
For 2008’s tax year, Roth IRA contributions have to be made by this April 15th—so don’t sleep on getting money in the accounts while you can. And while you’re at it, make a contribution for 2009, as well.
And if you think the Roth IRA is the solution to your retirement anxiety, wait until next month, when you’ll find out why now is a great time to consider converting some or all of your IRA to a Roth IRA.
