If so, you're not alone. Even if you're not one of those earning over $200k (or couples over $250k) that the President's proposed deficit plan would raise taxes on, ever growing budget deficits and entitlement spending are causing more and more people to wonder if they're next. In fact, tax rates are currently scheduled to increase across-the-board in 2013 if the law doesn't change between now and then.
One possible thing you can do is contribute to a Roth IRA (named after Senator William Roth in the picture above). Perhaps in response to a blog post I wrote called , we received an email on our asking exactly how to open one. This is quite a common question. After all, most of us are familiar with our 401(k) or whatever other retirement plan is offered by our employer. You may also have a traditional IRA after rolling a retirement plan from a previous job into one. But opening a Roth IRA remains a mystery to many.
Why a Roth IRA?
As you may have guessed, the main reason is to shelter gains in the account from taxes. Unlike a pre-tax 401(k) or traditional IRA, you don't have to pay taxes when you take money out of the account as long as you're over age 59 1/2 and you've had the account open for at least 5 years (one more reason to open it soon and get that clock ticking). The tradeoff is that you don't get to deduct your contributions from your taxes. This could make a Roth IRA more valuable than a pre-tax retirement account if you think your tax bracket will be higher in retirement, either because you're expecting to have higher income or you're worried that tax rates will go up as discussed earlier.
Even if you don't expect your tax bracket to be higher, a Roth IRA would be beneficial if you've maxed out your employer's plan and are looking for more tax-advantaged ways to save. It's not just for retirement either. Contributions may be withdrawn at any time for any purpose without tax or penalty, which means you can use it as part of your emergency fund. Also, after 5 years, the earnings can be withdrawn tax free to buy a home if you haven't owned one in the last 2 years (subject to a $10,000 lifetime limit). Otherwise, if you withdraw the earnings within 5 years of opening the account, or before the age of 59 1/2, they are generally taxable and may be subject to a 10% penalty.
How much can you contribute?
First, you can only contribute if you have earned income, so you may be out of luck if you're unemployed or retired the entire year. Second, there are limits based on your age, marital status, and income. You can use this to see how much you can contribute for this year.
When can you contribute?
Since you need to know your Modified Adjusted Gross Income for the calculation above, the good news is that you have until April 15th to contribute for the previous year. That means you can do your taxes, make sure you're eligible, and then use your refund to help fund the Roth contribution. Since there's no deduction, you don't need to file an amended return.
If your income is too high, don't worry. You can simply open a traditional IRA and then immediately convert it to a Roth IRA as there is no longer an income limit to do so. Just be aware that you may owe taxes on the conversion if you have ANY pre-tax IRAs, even if you're not converting them.
Where should you open the account?
This is not something that you can generally do at work. Instead, you have to open it at a financial institution. Here are some things to consider:
Know what you want to invest it in.
A common mistake is the idea that a Roth IRA is an investment. It's more like a bag that you can put investments into to protect them from taxes. What you invest it in, in turn, depends on what you want to do with it. If you want to keep it somewhere safe and accessible for emergencies or a short-term goal like a home purchase in the next 5 years, you might want to open it with a bank, credit union, or money market fund. If you accumulate an adequate amount of cash for these purposes outside the account, you can always transfer it to a brokerage or mutual fund company to be invested more aggressively for retirement.
Be a cheapskate.
Fees eat away at your returns and can add up to quite a bit over time. There are several types of fees to look out for. Some institutions charge a relatively small custodial fee to cover administrative expenses each year. If you invest it in stocks, bonds, mutual funds, or annuities, there could also be sales charges and commissions on the individual investments. You can minimize these by choosing a discount brokerage or no-load mutual fund company like Vanguard, Fidelity, Charles Schwab, TD Ameritrade, or Scottrade. Despite being "discount," each of these companies has representatives that are available to help you choose specific investments and fill out the paperwork. Finally, consider index funds if you want to minimize mutual fund management expenses and trading costs.
Keep things simple.
If an institution that you already have accounts with meets the above criteria, you may want to open your Roth IRA there too so you don't have accounts in too many places. This can cut down both your paperwork and legwork. You may also qualify for perks by keeping a certain amount of assets there. If you choose not to keep your accounts in one place, you can use a site like or to consolidate your account information online.
Hopefully these guidelines can help you open a Roth IRA if you haven't done so already. While you may not benefit now, you can reap the reward later, especially if taxes do go up. Then maybe you'll come to love the Roth IRA as well.
Are you looking for an unbiased answer to your own financial question? Once a week, we’ll be responding on this blog to questions from our Financial Helpline or posted on our or site.
Erik Carter, JD, CFP® is a resident financial planner at , the leading provider of unbiased financial education for employers nationwide, delivered by on-staff CERTIFIED FINANCIAL PLANNER™ professionals. For additional financial tips and insights, follow Financial Finesse on and become a fan on .
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