What Everyone Should Know About Roth IRA's

Our grandparents had it easy: work for 40 years, get a gold watch and well wishes, and live off a company pension for the rest of their lives.

Though the days of pensions are long gone, most people are still somewhat clueless when it comes to retirement savings options. 401(k), IRA, Roth, SIMPLE…What does it all mean? There are a ton of savings options out there for you, but by far one of the most valuable is the Roth IRA.

The Roth IRA is almost universally the best option for retirement savings, though it does have a few drawbacks. There are a few things everyone should know about the Roth IRA and why it should be a part of retirement planning.

1. Contributions are not tax-deductible. When you put money into a 401(k) or Traditional IRA, your contributions are taken from pre-tax dollars. This means that for every $1 you put into the plan, you are only losing a fraction of that from what would have been in your paycheck. However, a Roth IRA is paid for using after tax dollars, so every penny comes out of your take home pay.

2. But withdrawals are tax free. A Roth may not offer the tax advantages that other retirement accounts offer today, but in retirement the tax advantages are much higher. When you withdraw money from your Roth IRA in retirement, every single penny is tax free. This is important for three main reasons:
1) Tax rates are low right now, and are not guaranteed to stay that way. If tax rates increase, your new tax bracket is irrelevant to any Roth withdrawals in retirement.
2) Earnings are tax free, as well as contributions, so if you are still several years away from retirement, you can take advantage of compounding to essentially give yourself a nest egg that is tax-free.
3) Tax diversification can help your retirement savings last. Having several types of accounts, including a Roth IRA, can give you the choice of drawing from tax-free and taxable income in retirement, a strategy that you can employ based on your spending habits and the economic weather of the time.

3. Not everybody can contribute the full amount. If you are single and earn under $95,000 or married and earn under $150,000, you can contribute up to $4000 in 2006. If you are 50 or older, you can contribute an additional $1000, making your max contribution $5000. Contribution limits are gradually reduced above the cutoff point, and eventually disappear completely.

4. But everybody can convert. A recent tax loop makes it possible for anyone to convert a traditional IRA into a Roth, starting in 2010. This means that if you aren't within the limits to be able to contribute to a Roth (or even a deductible IRA), you can still contribute to a traditional, non-deductible IRA and then convert it to a Roth. You will have to pay taxes on the amount in the IRA, so make sure you can do that without taking away from the balance of the account. If you can pay the taxes, though, this is a great opportunity.

5. There are no required distributions. With a traditional IRA, as with many retirement accounts, you must begin to take distributions at age 70 ½; however, with a Roth, you don't have to withdraw anything at any point, making it possible for your tax-free compounding to continue to grow throughout your retirement.

6. Tax-free savings can be passed on. When you die, your Roth IRA can be passed on to your beneficiaries without estate taxes, no matter how much is in the account-or the rest of the estate.

7. Contributions can be withdrawn tax- and penalty-free at any time. Need an emergency fund? Or a down payment for a house? Or a way to pay for college? Any money you contribute to a Roth IRA can be withdrawn at any time. However, anything your contributions earn, including interest, will be subject to tax and penalties if withdrawn before age 59 ½ and before the account has been opened for five years.

All things equal, a Roth almost always beats a traditional IRA. And, as an added bonus, companies have begun offering a new Roth 401(k) with many of the same advantages. If you're one of the lucky few whose company is already offering this retirement option, you should consider signing up.

Whatever your retirement choice, it's a good bet to cover your bases and not wait around for a pension that you might never see.