May 7

Origins of the Roth IRA


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Some believe it was given to us by a superior alien race, while others think the idea came from ancient Egypt. Good theories, but both are incorrect :-).  Seriously, where did the Roth IRA come from? When did the Roth IRA come into existence? These questions and more are addressed in this post. The purpose of this post is not to sell you on a strategy, it’s just to take a look back at the origins of the Roth IRA. The Roth IRA is an important piece of a retirement strategy. Roth IRAs are a great way to limit taxable income in retirement. Additionally Roth IRAs are superior to traditional IRAs, if you as an investor plan on leaving a financial legacy to your family or favorite charity. This is the first post of a new series I’m authoring. I figured it’s interesting to take a look at the origins on retirement instruments.

Roth IRA Origins

Oh good, you decided to read on past my introduction. The Roth IRA was introduced as part of the Taxpayers Relief Act of 1997 (Public Law 105-34). Its named after the man who had the most influence over getting this concept pushed through congress. That man is William Roth, former senator of Delaware. William Roth was not the only person to drive the Roth IRA, but he was the sponsor of this legislation. In 1995, former Oregon senator Bob Packwood and William Roth developed the idea together. It was originally named the “IRA-Plus.” Then called the “American Dream Savings Account” or ADS account. Of the names, I like “IRA-Plus” better, but I suppose Roth deserved to have his name on this one. In Roth’s own words, “if you work hard and save hard, you can have a good retirement income that allows you to leave something to your children.”

Their first plan allowed individuals to invest up to $2,000 in an account with no immediate tax deductions, but the earnings could later be withdrawn tax-free at retirement. Today Roth IRA annual contribution limits are $5,500 per person under the age of 50, and $6,500 per person over the age of 50. When the Roth IRA was first introduced contribution limits were set at $2,000 regardless of age; this means there was not accelerated or catch-up contributions allowed for those over 50 years of age. Since 2008, the federal government has increased Roth IRA annual contributions every few years to account for inflation. See a year-by-year annual contribution chart below.

Major Differences Between the Roth IRA And Traditional IRA

These two IRA types shouldn’t be considered all or nothing investments. As an investor you can choose to take part in one or both as long as you don’t go over annual monetary limits. By this I mean, you can invest a maximum of $5,500; but the money can be spread across a traditional and Roth IRA. There are major differences between the two IRA types. The biggest difference is that a traditional IRA is funded with pre-tax dollars and a Roth IRA is funded with post-tax dollars. This of course leads to the next most important differentiation. changes the rules upon withdrawal. Traditional IRAs are taxed at time of withdrawal, whereas Roth IRA withdrawals are tax-free. An investor can put taxed money into an account and that account can grow to insane amounts with no tax consequences! Let’s pause for a moment of silence. How awesome is that?

Roth IRA Advantages

  • Principal contributions can be withdrawn at any time with no penalties or tax consequences.
  • After 5 years, and if an investor is over 59½ years old, earnings may be withdrawn with no penalties or tax consequences.
  • Money rolled over or converted from a retirement account, before the age of 59½ into a Roth IRA allows for withdrawals with no penalties or tax consequences.
  • If conditions are met distributions from a Roth IRA do not increase Adjusted Gross Income. This is opposite of a traditional IRA, where all withdrawals are taxed as ordinary income.
  • $10,000 in withdrawals are allowed to purchase a home as long as 24 months have passed since the last home purchase.
  • Qualified Roth distributions do not affect taxable social security benefits. Known as the Provisional Income Threshold, this calculation determines how much of your social security income will be taxed.
  • If you as a Roth IRA owner die, your spouse will become the sole beneficiary of that Roth IRA. Your spouse can combine their Roth with yours without penalty.
  • Roth IRAs allow investors to leave Roth IRAs to their children or other beneficiaries, charities, non-profits, that they choose. There are no tax implications when Roth IRAs are transferred to a spouse at death. Non-spouse beneficiaries have options on how to disburse a Roth IRA. Long story short, Roth IRAs can be passed on to your children, grandchildren, etc.
  • Roth IRAs don’t require distributions at a certain age. If a Roth IRA owner wants to leave it to their offspring, they can let their money grow tax-free an upon death, leave the entire Roth to their beneficiaries. Those who inherit Roth IRAs will be held to  minimum distribution rules.
  • Diversification of tax risk. If an investor has 50% of their money in pre-tax accounts and the other 50% in post-tax accounts, they can offset large sums of taxable income in a given year. This is because Roth IRA distributions don’t count towards income.

Roth IRA Disadvantages

  • Roth IRA contributions are not tax-deductible. Investors who contribute to a traditional IRA instead of a Roth IRA get immediate tax savings equal to the amount of the contribution multiplied by their marginal tax rate. This is important to understand and verify each year, because a tax deduction could reduce an investors overall tax bracket rate. In some cases, even if an investor prefers Roth IRAs, a traditional one may be the best decision. This should be considered each tax year.
  • High Income earners cannot contribute directly to Roth IRAs, if their income surpasses a certain level. This is often misunderstood and requires more explanation. If an investor make more than the allowable annual income limit, that investor cannot directly fund a Roth IRA. Damn, that sucks. Wait, there’s a workaround called a Backdoor Roth Conversion. Trust me this works. I fund 2 Roth IRAs every year through backdoor conversions. It takes a few minutes and generally can be handled online.
  • Roth IRA contributions are taxed at a investors current income tax rate, which may be higher today than it will be at retirement.
  • Roth IRA tax-free benefits may never be realized. If you don’t live to retirement, you would’ve paid taxes on investment principal and you will never get the tax-free benefit.
  • Congress may change the rules that allow for tax-free withdrawal of Roth IRA contributions. This really is the biggest risk to Roth IRAs. What if the government got greedy. Wait, that never happens! It’s doubtful it will happen, but one can never be too wary of their government. If this did occur, traditional IRA contributors are the winners. Because they got immediate tax benefits and Roth investors waited for those benefits in retirement.

Roth IRA Distributions

If you read above and didn’t skim this page you already know what I going to write. But I’ll write is again. Withdrawals of returns from your Roth IRA are always withdrawn tax-free if the following conditions are met. Five years must have passed since the opening of the Roth IRA, and a justification must be verified, such as retirement or disability. Once an investor hits 59½ years of age, Roth withdrawals are tax-free without penalty or restriction.

When Does A Roth IRA Make Sense

Your asking the wrong guy. I think they always make sense. The general consensus is that they make sense if you are young enough to allow for enough time to grow your Roth IRA to a large amount. Remember all growth is tax-free, so with enough time, a Roth should reach a point where earnings far surpass any immediate tax savings. For me they make sense always, because my plan is to live off of dividends and leave my principal behind. A Roth allows for this, because I don;t need to take disbursements. I’ll only take what I need to live on and leave the rest to my family.

Roth IRAs – My Perspective

If you haven’t figured it out yet, I love the Roth IRA. If I could, every penny I invest would be invested in a Roth IRA. The battle over which IRA is better will go on forever, but for my money, It’s a Roth. Why? As investors we try to avoid unknowns. This is why we evaluate companies, read annual reports, subscribe to financial information services, etc. We don’t want to be surprised, so why would we gamble on future tax rates? It’s easy to say that your retirement tax rate will be lower, but will it? You cannot be certain of that. The only tax rate certainty is investing post tax into Roth IRAs.

As I’ve written about before, I want to leave behind a sizable amount to my children to be used as a Family Bank. My Roth IRAs can make this happen, if I’m diligent and keep on investing.

Closing Thoughts

There are more advantages and disadvantages to Roth IRAs. There are also other interesting tactics that can be implemented to invest even more into a Roth IRA. The College Investor just wrote a great post about the Mega Backdoor Roth IRA. This baby is like cooking with gas. What I’m saying is there’s a lot more to read about and understand before choosing your IRA investment type. This post is meant to cover the basics.

Now it’s your turn. Which IRA do you think is better, a traditional or a Roth IRA? Do you invest in either IRA type? Do you think I’m crazy?


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