Change Counts

A general mantra professed by the investment management industry is that it is never too late or too early to begin saving for the future. Even in these tough economic times, this financial imperative should be addressed with some attempt at rearranging budget priorities and setting aside a regular amount from each month’s income for this obvious need. Our government firmly supports this effort and has created a number of programs within its tax code to encourage participation in various savings programs.

Most individuals have learned of these programs through plans offered by their employers in the form of 401(k) savings plans. If you are not covered by one of these plans, then an “Individual Retirement Account”, or “IRA”, can be set up with your banker or broker to provide tax-sheltered benefits going forward on your personal contributions. While most of us are familiar with the notion of an IRA, many consumers are unaware that there are two types of an IRA, the most recent creation being the “Roth IRA”.

The concept of an IRA was created decades ago, but in 1998, a new form was developed, the “Roth IRA”, named after a late senator from our Congress. This special form of a savings account addressed many of the shortcomings of a standard IRA that prevented many consumers from taking advantage of these aspects of the tax code. For example, if you participated in an employer-sponsored plan at work, then you could not have a separate IRA. If you did have a traditional IRA, you also faced excessive tax penalties for early withdrawals, and withdrawing your funds was required after you reached an age of 70 ½.

Here is a brief list of the basis benefits of a Roth IRA:

You may participate in a Roth IRA, even if you are in an employer plan;
You may make withdrawals at any time without the imposition of a tax penalty;
You do not have to make withdrawals after 70 ½, and you may continue to make contributions;
You may convert a standard IRA to a Roth IRA;
Withdrawals are tax free up to the point that your original contributions have been withdrawn. You then pay tax on any “converted” contributions from a standard IRA, but your earnings while under the Roth IRA are tax free, subject to certain rules.

The government never uses taxpayer monies to subsidize a certain program without restrictions, and the same can be said for Roth IRAs. These restrictions, however, are fairly straightforward for the general public. Here is another brief list:

You do not get a tax deduction for your contributions of savings or net working capital ;
In 2011, you may contribute up to $5,000 as long as you or your spouse has qualifying income in excess of that amount for the year;
If you are over the age of 50, your contribution limit increases to $6,000;
If your Adjusted Gross Income exceeds certain levels ($107,000 for single individuals and $169,000 for married couples filing joint returns), then your allowable contributions will be reduced according to IRS table values;
You may convert a standard IRA to a Roth IRA, but there may be conversion taxes to pay. Consult your tax advisor to determine if conversion works for you in the long run.

The real benefits of pursuing a Roth IRA savings strategy are on the distribution side of the equation. Although you give up a tax deduction to make contributions of savings or net working capital, something permitted with a standard IRA, you can make withdrawals of your contributions at any time without the risk of a penalty or the need to report ordinary income in the year of withdrawal. However, the earnings on your contributions are not taxed when earned, nor are they ever taxed as long as at least five years have passed since you set up your Roth IRA and you are over 59 ½ years of age.

Since everyone’s personal finances are different, consult a professional investment advisor or your banker to assess if a Roth IRA is a prudent investment tool for your unique situation.