The key fact about a Roth IRA is that it allows Tax-Free Growth of After-Tax Money with no excess fees. For instance, if you take $1000 from your bank account (after-tax money: you have already paid income taxes on it) and put it in a Roth IRA mutual fund, then you will never pay taxes on what it earns. Or if you put that $1000 of after-tax money in a deductible IRA, along with the taxes that the IRS "loans" you (by giving you a rebate on your income tax payment or withholding), and if your tax rate when you withdraw it is the same, then you will also have Tax-Free Growth Of Your After-Tax Money (since all you pay the IRS in taxes is its loan plus the earnings on that loan).

By contrast, after-tax money put in a regular variable annuity grows without taxes only until you take it out, when you have to pay taxes on all of the earnings. That is only a tax-deferral, not a tax-free shelter of all earnings on your after-tax money.

Rules For An Ordinary Roth IRA

If your earned income as a single unmarried taxpayer is at least $2000 and at most $95,000 for 1998, you can deposit $2000 with a mutual fund company of your choice to start a Roth IRA. For married people filing jointly, if your joint earned income is at least $4000 but not over $150,000 for 1998, each of you can deposit $2000 in a Roth IRA. "Earned income" does not include interest, capital gains, or pension income.

These IRAs are kept in individual accounts; you cannot put the whole $4000 in just one person's name or in a joint account. If you make a mistake and establish an IRA when you are not within the required limits, you can easily fix it by having the excess (along with its earnings) returned to you before April 15 of the following year and paying taxes on those earnings.

You cannot take the earnings out of the Roth IRA until the year you turn 59.5 years old without a hefty penalty. Even then, you have to wait until the fifth year after you created the Roth IRA. But you can take out the $2000 you contributed without penalty whenever you want. In particular, if you have cash reserves that you keep available for an emergency (such as losing your job or a serious medical problem), but you really do not expect to need it, you can put it in a Roth IRA. If the emergency occurs, you can take out the original $2000; but you should leave the earnings in.

All of your earnings on the Roth IRA are tax-free, no matter what buys and sells you make within the Roth IRA. When you die, the beneficiary you name receives the money in the account free of probate and income taxes, but it does not continue to be a Roth IRA anymore; whatever it earns after your death is taxed. One exception is that your spouse can take it over and treat it as her own Roth IRA, continuing the tax-free growth. Another exception is that a non-spouse heir can choose to take a regular income from it for life. This continues the tax-free growth on the earnings, but the decision and the amount of annual income cannot be changed later.

One catch is that the advantages may be reduced by government action in the future. Your state government may tax the earnings even though the federal government does not. Or the federal government may in the future decide to count the earnings in deciding how much of your social security income to tax; this amounts to an indirect tax on the Roth earnings.

Rules For A Deductible IRA

Conditions for starting a deductible IRA are the same as for a Roth IRA except that the income limits for full deductibility when you have an employer-sponsored pension plan are $30,000 for a single tax-payer and $50,000 for a joint return. If one spouse has an employer-sponsored pension plan and the other does not, then that other can put $2,000 in a deductible IRA as long as the total income is less than $150,000.

For each $100 you put in a deductible IRA, you get $32 back as an income tax rebate (if you are at the 32% combined federal and state tax rate; similarly for other rates). But when you withdraw $100 from a deductible IRA, you have to pay $32 in income taxes on it (again, assuming 32% tax rate at withdrawal). So an amount in a deductible IRA is worth to you only a certain percentage of its nominal value as reported by the mutual fund or other trustee (the percentage depends on your income tax rate).

There are other differences that affect the decision as to which kind of IRA is better, namely:

1. Starting with the year in which you reach age 70.5, you must start taking distributions from a deductible IRA that tend to deplete the account over about 20 years; but not from a Roth IRA.
2. You cannot add to a deductible IRA after age 70.5, but you can add to a Roth IRA any time that you have earned income.
3. You can cash in a deductible IRA in less than 5 years, as long as you are 59.5.
4. You can start taking a regular income from a deductible IRA well before age 59.5, though the rules for this are rather complex.
5. If you die with a deductible IRA whose beneficiary is a charity, you avoid all income taxes on it (as well as estate taxes). By contrast, if it is a Roth IRA, you have paid unnecessary income taxes.
6. You can contribute more after-tax dollars to a Roth IRA than to a deductible IRA. This is because the $2000 limit for a Roth IRA is all in after-tax dollars, but the $2000 limit for a deductible IRA includes the taxes saved. For $2000 deductible IRA, at the 32% tax rate, $640 of the $2000 belongs to the taxman, and only $1360 is yours. So you have in effect managed to tax-shelter only $1360 of your own money instead of the $2000 the Roth IRA would allow.

Calculating The Return-On-Investment (ROI) For A Deductible IRA

If your tax rate when you cash in the deductible IRA is the same as it was when you invested it, then it gives you exactly the same Tax-Free Growth of After-Tax Money that a Roth IRA does. But the process is somewhat circuitous. Specifically, if you are at the 32% tax rate, and you take $1000 from your bank account (after-tax money; you have already paid the taxes on it) and put it in a deductible IRA, you can add to it the $471 that the taxman gives you (by reducing the taxes you pay that year or increasing your tax refund). When you take the money out some years later, along with all of its earnings, you have to pay the IRS its $471 plus all of its earnings (it wasn't a gift, it was a loan). But you still get tax-free growth on your own after-tax money (the "investment" part of ROI).

The tricky part here is that a deductible IRA requires pre-tax money, so the $1471 is the pre-tax equivalent of $1000 post-tax (because 32% of $1471 is $471). Then when you cash the IRA in, you receive pre-tax money on which you have to pay taxes. If your tax rate is lower when you take it out than it was when you put it in, you come out better than the Roth IRA. If your tax rate is higher, you come out behind. I believe that the vast majority of people have a lower overall tax rate in retirement.

For example, say this investment of $1000 out-of-pocket cost grows by a factor of 10 by the year you cash it in. So the nominal $1471 in the deductible IRA grows to $14,710. This $14,710 is in two parts: Your $1000 has grown tax-free to $10,000, and the IRS's $471 has grown to $4710. If your tax rate is 32% when you cash in, you get your whole $10,000; that is tax-free growth of the $1000 of after-tax cost. But if your tax rate is 15% when you cash in, you get to keep $12,500, which is a bonus of $2,500. On the other hand, if your tax rate is 36% when you cash in, you get to keep only 64% of $14,710, which is $9410, a loss of $590 relative to tax-free growth of the after-tax money.

Some FAQs For Roth IRAs

Can I pay the IRA fees from post-tax money? Yes, if they are annual account fees, such as a $10 fee for account balances under $5000. No, if they are broker or sales commission fees.

Can I contribute $2000 to each of a regular IRA and a Roth IRA? No, only a total of $2000 combined. However, you can do this even though you add money to a SEP or SIMPLE IRA.

Can I contribute $2000 to a Roth IRA if I file taxes married filing separately? No. Why not? That isn't logical! You expect logic from the IRS?

Can my child have a Roth IRA? Only if she has earned income. It should be verified by a W-2. Interest income does not count. But you need not have earned income if your spouse has enough.

Can I purchase a Roth IRA with stock? No, you have to sell the stock, pay the taxes on the profits, and purchase the Roth IRA with the cash. Your provider may allow you to move stock from an ordinary IRA to a conversion Roth IRA without selling it, but you will pay tax on the current value.

Can I convert a 401(k) or 403(b) directly to a Roth IRA? No. However, if you are old enough to convert some or all of the 4xx plan to an ordinary IRA, you can then convert that to a Roth IRA. Or if you leave an employer and put your 401(k) in a Rollover IRA, you can then convert that.

Can I convert the money in a regular commercial variable annuity to an IRA? No, not if it was purchased with post-tax money. But if it is part of a 403(b) plan, see the previous question.