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 Also, any capital gains you make on your Roth IRA investments can be withdrawn tax-free!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ii) Upto $10,000 can be withdrawn without any penalty if the owner wishes to purchase a home or principal residence.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.

The important benefits of contributing towards an IRA are the tax deductions against annual income, tax-free growth of earnings and the non-refundable tax credits. You want to maximize the returns you get from contributing to your IRA, therefore it is essential to know the rules & limits placed behind these privileges we just mentioned.

i) IRA Tax Deductions: In a traditional IRA, any contributions you make are tax-deductible and any withdrawals you make will be taxed by the federal government upon withdrawal. However, if you contribute to an SEP IRA, Simple IRA or a Qualified IRA plan, you are considered an ‘active participant’ and the deductibility of your contributions is determined by your modified adjusted gross income (MAGI). The deductibility of your contributions is also determined by your tax-filing status; whether you are ‘married filing separately’, ‘married filing jointly’ or ‘single.’

If your Traditional IRA contributions are not tax-deductible, you can still contribute towards a traditional IRA. Alternatively, you can contribute towards a Roth IRA, here are the modified adjusted gross income (MAGI) limits.

Note: If your income falls in between the ranges that allow only ‘partial contributions’, you can use a special formula to determine that partial contribution.

Tip: If you are married but have lived away from your spouse for the entire tax year, you are not considered as ‘married’ for tax filing purposes. Your Roth IRA MAGI limits will be based on single limitations.

Note: If you make a non-deductible contribution to your traditional IRA, make sure you fill out IRS Form 8606. This form will help you and the IRS keep track of non-taxable balances in your Traditional IRA, should you make any withdrawals upon retirement. Download IRS form 8606 @ www.irs.gov

Split Your Contributions: Splitting your contributions between a traditional IRA and a Roth IRA can be beneficial in some cases. These cases are if:

i) You are eligible only for partial contributions to a traditional IRA. Instead of contributing the non-tax deductible amount to the traditional IRA (and grow it tax-deferred), contribute it to a Roth IRA where it grows tax-free.

ii) You are eligible only for partial contribution to a Roth IRA. To maximize your contributions for the year, contribute the remaining difference to a traditional IRA.

Note: Your combined contributions to a Roth IRA and a traditional IRA should NOT exceed stated IRA contribution limits of $5000 for the year 2010.

IRA Tax Credits: You might be eligible for a non-refundable tax credit of up to 50% of your IRA contributions depending on your adjusted gross income and tax-filing status. Here is the table specifying tax credits under each tax-filing status.

These non-refundable tax credits are allowed in addition to any deductions you get for your IRA contributions. To claim the non-refundable tax credits, be sure to file IRS Form 8880.