Roth IRAs

I told you yesterday that I loved Roth IRAs, and today, I'm going to tell you why. Roth IRAs are funded with after-tax dollars, so you don't get a tax deduction at the time you invest your money. However, if your Roth has been open for five years, and you are at least 59 1/2, you pay no taxes on any distribution. In other words, the growth is tax free!

In addition, Roth IRAs don't have the same kind of penalties for early withdrawals as a traditional IRA. If you fund an IRA and you later need the money, as long as you only withdraw the money you invested, you pay no tax and no penalty. Let's look at an example:

You invest $5,000 in your Roth this year, and you earn $500 in growth, making your account balance $5500. If you have an emergency, you can take a tax-free distribution from this Roth, regardless of your age and regardless of when you funded it, for $5,000. If you touch the $500 growth, you will owe taxes and penalties.

This is somewhat logical, since you already paid your taxes on the $5,000 before you put it in the account. However, it's a very nice feature, especially for a young investor who can't imagine tying up money until she is 59 1/2.

The other advantage to the Roth is that you don't have to take Required Minimum Distributions (RMDs) when you're 70 1/2 from your own Roth. You can maintain the account and pass it to heirs. Therefore, the principle has longer to grow before distributions must be made. Also, as long as you have earned income, you can fund your Roth after the age of 70 1/2.

In 2010, you can fund your Roth with $5,000, assuming you don't fund a traditional IRA. (The total funding of both cannot exceed $5,000). If you are 50 or older, you can invest an additional $1000.

If you are single, you can fully fund a Roth if you earn less than $105,000 a year. You cannot fund a Roth at all if you earn more than $120,000. The $15,000 phaseout allows partial funding. If you are married, filing a joint return, you can fully fund a Roth if you and your spouse earn less than $166,000, and you cannot fund at all if you earn more than $176,000. The $10,000 phaseout (yes, I know it makes no sense when compared to the single phaseout) allows partial funding.