Studies indicate that many people do not save for retirement because they do not understand all the 401k gibberish. First there’s the traditional 401k, then there’s the Roth 401k, annuities, ROTH IRA, Individual Retirement Accounts (IRAs) and your savings account at your local bank. Out of all these options, the Roth IRA has come out to be the best and the most popular option. Why? Because its tax-free growth and flexibility of making withdrawals cannot be competed against! Studies suggest that compared to traditional 401k or 403b plans, a retiree who saves in a Roth IRA will have more savings upon retirement. Total Roth IRA assets in the United States totaled $178 billion as of December 2006 (Source: Investment Company Institute).

The Roth IRA was introduced under the Taxpayer Relief Act of 1997, pioneered by the late Senator William V. Roth, Jr. Under a Roth IRA, an individual can invest in all types of investment vehicles including common stocks, mutual funds, futures & options, certificates of deposit, as well as real estate. The main advantage of Roth IRA is its tax structure. Contributions to a Roth IRA are made only from earned income that has been taxed by the Federal government. Since you already pay taxes before saving your money in a Roth IRA, you are not required to pay federal taxes when you make withdrawals from your Roth IRA. Also, any capital gains you make on your Roth IRA investments can be withdrawn tax-free!

Difference between Traditional IRA and Roth IRA

In a traditional IRA, any contributions you make are tax-deductible and any withdrawals you make will be taxed by the federal government. This works inversely with a Roth IRA where any contributions you make is not tax-deductible (because you have already paid taxes on this), and any withdrawals you make will NOT be taxed by the federal government.

Roth IRA Contribution Limits

Advantages of Roth IRA

i) Roth IRA owners can withdraw up to the total value of their contributions at any point in time, without having to pay the 10% early withdrawal penalty or any federal income taxes.

ii) Upto $10,000 can be withdrawn without any penalty if the owner wishes to purchase a home or principal residence. The home must be purchased by either the Roth IRA owner, his spouse, ancestors or descendants. Also, the Roth IRA owner must not have previously owned a home for at least 24 months.

iii) If a Roth IRA owner dies and his spouse also owns a separate Roth IRA, the spouse is permitted to combine the two Roth IRAs into 1 single account without any penalties or fines.

iv) The Roth IRA does not force distributions upon the owner reaching 70 and 1/2 years of age. This is unlike all tax-deferred retirement plans including the Roth 401k where the owner is required to take minimum required distributions (MRDs) after the age of 70 and 1/2 years. Usually all distributions must be withdrawn by April 1st of the calender year.

v) If the Roth IRA owner expects to be in a higher tax bracket upon retirement, it is advantageous for him to contribute maximum amounts of money towards a Roth IRA. Why? Because money being invested in a Roth IRA is taxed at the current lower tax bracket, and will not be taxed when it is withdrawn upon retirement (and when the Roth IRA owner is in a higher tax bracket). For example, consider an investor who contributes $2000 to a Roth IRA when he is in a tax bracket of 21%, and will be in a tax bracket of 33% upon retirement. This means that investor has already paid 21% x $2000 = $420 in taxes. Upon retirement if the investor wants to withdraw his funds, he would have had to pay 33% x $2000 = $660 under a Traditional IRA. However since the investor has already been taxed at his lower bracket of 21%, he would NOT have to pay taxes upon taking retirement distributions when he is in a 33% tax bracket.

Introduced in January 2006 under a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001, the Roth 401k is different from the traditional 401k plan because contributions are made after-tax (meaning after tax has been deducted off your pay). The Roth 401k is very similar to the Roth IRA; investors receive no tax deduction on annual contributions, but any withdrawals or proceeds will not be subject to tax either. Investors who own 403b plans are also eligible to contribute to Roth 401k. The government was more than happy to introduce this new piece of legislation because it means investors will pay more tax now, rather than making salary deferral contributions as in the case of traditional 401k plans.

The Roth 401k works inversely with a traditional IRA. With a traditional IRA, an investor receives current tax deduction after making contributions. Instead of this money going to the IRS now, it will stay with the investor and he can invest it in stocks/bonds/mutual funds or real estate. Over time, this money will grow tax-deferred. The government likes this idea too because say after 30 years of investing in various stocks/commodities/real estate, an investor has grown his money from $50,000 to $200,000. If he withdraws this money from his IRA, he will have to pay taxes not on the initial $50,000 but on the whole $200,000!

The Roth 401k works inverse with the above idea. The money you earn this year is taxed this year. You make contributions to a Roth 401k from your after-tax earnings. When you reach the age of 59.5 or more, you are eligible to make withdrawals that are not taxable (because they have already been taxed). The prospect of receiving tax-free money upon retirement is an idea liked by many investors. The idea of receiving tax dollars now is very much liked by the government such that some senators have proposed getting rid of traditional 401k plans or IRAs.

Roth 401k Works Best if:

• The federal government increases taxes over time
• You are a high income earner who has a compensation cap on Roth IRAs (maximum compensation cap of $245,000 in 2011)
• The mutual funds or stocks where you put your Roth 401k capital experience significant returns
• You are a young investor and need more time for your account to grow across various investments such as mutual funds, stocks, commodities, etc.
• You are in a lower tax bracket now and will be in a higher tax bracket upon retirement

Understand the Advantages of Roth 401k

i) Unlike the Roth IRA that has income limitations that will restrict high income earners from deducting the maximum tax off their earnings, the Roth 401k has no income limitations. The maximum compensation cap for Roth IRA is $101,000 for 1 individual, or $159,000 for for joint tax payers. In the case of the Roth 401k, there is no such compensation cap.

Note: The contribution limit for Roth 401k for 2011 is $16,500 for people under the age of 50, and $22,000 for people over the age of 50.

ii) Roth 401k provides tax-free withdrawals upon your retirement, and this idea is very appealing to investors.

iii) Also because of uncertainty regarding future tax legislation, it is better to lock in a lower tax rate now, than to wait upon retirement and pay taxes then. This is especially true for young investors who are earning lower incomes.

Disadvantages of Roth 401k

i) If you get terminated from your job or laid off and are forced to take a distribution of your Roth 401k assets, you are NOT exempt from paying taxes and will have to pay them.

Important Things You Should Know

Here are some of the important characteristics of Roth 401k that you should know about

i) Roth 401k is Voluntary – That’s right, Roth 401k is voluntary for employers. In order to offer Roth 401k for their employees, employers have to set up a tracking system that segregates Roth assets from the company’s existing plan. This tracking system is expensive to build and maintain, and employers may not choose to do it at all. If so, your employer will not be eligible to offer Roth 401k.

ii) Also, any matching contributions that your employer makes towards your Roth 401k must be deposited into a traditional 401k plan. Go figure!

iii) Unlike Roth IRAs, people who reach over the age of 70 and 1/2 must take minimum required distributions (MRDs) from their Roth 401k. This forces investors to take distributions even if they don’t want them or need them. Why wouldn’t they want them? Some investors like to leave behind inheritances for their children and grandchildren, and taking MRDs is not an option.

iv) If you think you are in a lower tax bracket now and will be in a higher tax bracket upon retirement, use a Roth 401k. If you think you will be in a lower tax bracket upon retirement and are thus in a higher tax bracket now, a traditional 401k makes sense.

v) Assets in a traditional 401k cannot be converted into a Roth 401k.

The Roth IRA was created by the Taxpayer Relief Act of 1997, pioneered by the late Senator William V. Roth, Jr. and was made effective on January 1st, 1998. Before 1998, investors who wanted to contribute towards an IRA would either make a deductible or non-deductible contribution to a Traditional IRA. Distributions taken from a traditional IRA were taxed as normal income, and early withdrawals before the age of 59 and a 1/2 were subject to a 10% early withdrawal penalty. The Roth IRA allows investors to take tax-free qualified distributions from their Roth IRAs without having to pay the 10% penalty. Here’s how it works.

Qualified Roth IRA Distributions?

Non-qualified Roth IRA distributions will be subject to normal income tax and a 10% early withdrawal penalty. A qualified distribution on the other hand must meet these criteria:

i) The distribution occurs at least 5 years after the investor established and funded his Roth IRA account. For this purpose, the five year period begins with the first day of the year for which the first contribution was made. For example, if the contribution was made on April 14th, 200, the 5 year period begins January 1st, 2000.

ii) The distribution must be taken under one of the following circumstances:

• the Roth IRA investor must be 59 and 1/2 years or older at the time of the distribution
• the Roth IRA investor becomes disabled at the time of taking the distributions
• the Roth IRA investor dies and his/her beneficiary receives the assets contained in the plan
• the distributions taken from the Roth IRA will be used in the purchase or building of a new home for the Roth IRA holder or qualified family member. This is limited to $10,000 per person per lifetime. Qualified family members include:
• the Roth IRA investor
• the Roth IRA investor’s spouse
• children of the Roth IRA investor
• grandchildren of the Roth IRA investor
• parent or ancestor of the Roth IRA investor

Taxing the Non Qualified Roth IRA Distributions

How non-qualified Roth IRA distributions are taxed depends on the source of the Roth IRA’s assets. There are 4 possible sources of Roth IRA assets:

• Normal contributions by the investor
• Earnings received on all contributions made by the Roth IRA investor
• Roth conversion of taxable traditional IRA assets
• Roth conversion of nontaxable traditional IRA assets

The IRS uses the source of the Roth IRA’s assets to determine ‘ordering rules’ of how assets will be distributed from the Roth IRA account. They are distributed in the following order:

1. Normal Roth IRA contributions by the holder
2. Taxable traditional IRA conversions
3. Non-taxable traditional IRA conversions
4. Capital gains and earnings made on all Roth IRA assets

Important Fine Print

i) Distributions of Roth IRA assets from normal participant contributions and from non-taxable conversions of traditional IRA assets can be taken anytime, tax free, if the 2 above criteria are met.

ii) Non qualified distributions of taxable traditional IRA conversion assets are subject to 10% early withdrawal penalties.

iii) Non qualified distribution of capital gains & earnings on normal contributions may be subject to income tax and 10% penalty.

Illustration

Simon established his first Roth IRA in 2002 and made annual participant contributions of $2000. In 2006, he converted his Traditional IRA assets to his Roth IRA for $40,000 (which was established in 2002). In 2007, Simon turns 55 years of age and wants to make some distributions of his assets. Here is his Roth IRA asset account at this time.

Assets Source

Simon wants to know the tax consequences if he distributes assets from his Roth IRA. Remember that assets are distributed in the following order; i) normal participant contributions ii) traditional IRA conversions iii) earnings.

i) Distribution of $10,000

A distribution of $10,000 is tax and penalty free because it comes from normal participant contributions made by John. Normal participant contributions have no waiting period for distributions and are tax free according to the IRS.

ii) Distribution of $25,000

The first $10,000 out of the $25,000 is tax and penalty free because it comes from normal participant contributions made by John (in Case i). The other $15,000 comes from taxable traditional IRA conversions made in 2006. Because these conversion assets were taxed when converted, they are not subject to tax now. However, they will be subject to the 10% early withdrawal penalty fee unless 5 years have passed since the conversion was made. The penalty can still be waived if any of these criteria is met:

i) Simon is 59 and 1/2 years of age or older (Simon is 55 at this time so this does not apply)
ii) Simon plans to use the distributed funds to purchase or build a new home for himself or his children, grand parents, spouse. There is a limit of $10,000 that can be distributed tax free.
iii) Simon becomes disabled before the distribution occurs
iv) Simon dies and his beneficiary takes over the assets
v) Simon uses the funds for medical expenses that are not reimbursable
vi) Simon uses the funds for higher education, college and university tuition fees
vii) Simon pays for medical insurance after an unfortunate job loss
viii) Simon’s assets are distributed as part of an IRS levy

iii) Distribution of $60,000

The first $10,000 withdrawn is penalty and tax free as in Cases i and ii. The other $40,000 is not subject to tax because the conversion assets were already taxed when the conversion occured, as in Case ii. The remaining $10,000 is attributed to non-taxable conversion assets and is not taxable because no deductions were allowed when assets were contributed to the Traditional IRA.

iv) Distribution of $65,000

Up to $60,000 of the funds will be treated as explained in Cases i to iii. The remaining $5000 is not subject to tax because Simon has had his Roth IRA for 5+ years and if he meets one of the following criteria:

i) Simon is 59 and 1/2 years of age or older (Simon is 55 at this time so this does not apply)
ii) Simon plans to use the distributed funds to purchase or build a new home for himself or his children, grand parents, spouse. There is a limit of $10,000 that can be distributed tax free.
iii) Simon becomes disabled before the distribution occurs
iv) Simon dies and his beneficiary takes over the assets

If none of these 4 rules apply to Simon, then his $5000 will be subject to income taxes as well as the 10% early distribution penalty.

Conclusive Points

• If an IRA holder does multiple Roth conversions, the 5 year period for each conversion is determined separately.
• If excess contributions are made to a Roth IRA and later withdrawn, these contributions cannot be included as part of ‘normal participant contributions’ for qualified distributions
• Roth IRA holders should keep a record of all their transactions and file the appropriate documents with the IRS for each of their transactions.