Roth IRA Contributions Become Tax Free Retirement Money

When we are young it is hard to look more than two or three years down the road in terms of life planning. In fact, the old "where do you want to be in five years" interview questions stumps most under thirty-five (and many even older). Recent news reports on baby boomers preparing for retirement have some younger generations starting to think about their own retirement. The social security insolvency issue is also motivating younger generations who have all but written off the hopes for social security supplementation during their own retirement. In preparing for that retirement there is a wonderful tool that many young people overlook, the Roth IRA.

Roth IRA vs. 401k
The Roth IRA provides a tax free retirement vehicle funded by after-tax dollars. In other words, contributions to Roth IRA's are not tax deductible, but when withdrawn during your golden years you owe no taxes on those withdrawals. On the other hand, 401k accounts grow tax deferred, meaning contributions are deducted from your income in the year you make contributions, but taxes are assessed upon withdrawal. So which strategy is best? Honestly, a combination of the two probably makes the most sense. Many employers match 401k contributions, and turning down free money doesn't make much sense. If you are fortunate enough to work for a company that matches contributions then I recommend funding a 401k through that matching percentage. If your company matches the first 4% then you should fund 4% of your salary towards a 401k. Any additional retirement funding should be directed towards a Roth IRA to take advantage of the tax free growth.

Taxes on the Seed or the Harvest?
One of the best analogies I've ever heard regarding the comparison between a Roth IRA and a 401k in terms of taxation is "would you rather pay taxes on the seed or the harvest?" In other words, would you rather pay taxes on your contributions early in your career, or on the eventual hundreds of thousands of dollars you may amass in a tax-deferred account such as a 401k. Common sense tells us to pay taxes on the "seed," or on the after-tax contributions made to a Roth while your income is relatively low. Sure, you won't get a tax break now, but the tax free withdrawals in retirement are well worth the sacrifice.

Limitations
Currently, individuals may contribute up to $4,000 of earned income in a tax year (this amount increases to $5,000 in 2008. If you are over 50 years old you may make an additional $1,000 contribution referred to as "catch-up" contributions. Our government regulations continue to punish the most successful wage earners in our society, so married couples making over $166,000 do not qualify ($114,000 for single filers). Married couples filing joint returns that make between $156,000 and $165,999 may qualify to make a partial contribution (see IRS publication 590 for details).