Start your ROTH… Now!

If you are in your twenties, you should be thinking now about your retirement nest-egg. Why? Simply, the earlier you start the more you get to benefit from the power of compound interest? If you invest $1 when you are 25, that dollar may be worth as much as $21. If, however, you wait until you are 35, to save that dollar, it will be worth around $10, or less than half of the total amount (calculations assume 8% annual return). Every dollar you save when you are 25 is worth two dollars when you are 35.

Where should you put that dollar and how should you invest it? There are a number of viable options that the United States government has created to allow you save that dollar and reduce your taxes. One of the most powerful tools the government has created is called a ROTH IRA. This is different than your 401(k) plan and your normal IRA, and we will explain the differences.

Beyond the regular benefits of a ROTH IRA, there are some special benefits that are only available during 2010. This means if you are considering converting, 2010 is the year to do it! These benefits are addressed below.

What is a ROTH IRA?

A ROTH IRA is different than other tax-sheltered retirement accounts. In traditional accounts, the money you put in today is not taxed until you take it out. You put it in today tax free, and you pay taxes when you take it out. This is frequently a good deal and, particularly when tied with potential matching or money from your employer in a 401(k) plan may be a good tool in your retirement arsenal.

The ROTH is basically the reverse of that. With the ROTH, you put the money in today after you pay taxes on it. Then the money grows as you invest it until you retire. Once you retire, you take the money out without paying taxes on it. All the money you earn until you retire is completely tax free. Of course, there are some restrictions to this and we will discuss those next.

Who can use a ROTH?

To setup and contribute to a ROTH account, you must have earned taxable income during the year. Assuming you have a job, that is no problem.

How much can I contribute?

In general, the limits are $5,000 per year but, as always, there are some complications. First, you are limited by the amount of income you actually earned. If you only earned $1500 during the year, you cannot contribute more than that. There are also restrictions on the high end as well. The contribution limits begin to reduce when your income hits $105,000 for singles and $166,000 for married taxpayers. You can contribute no money if your income hits $120,000 or $176,000.

What if I already have a traditional IRA?

Good news, you can convert your existing IRA to a ROTH IRA. You will probably have to pay taxes on the money you covert, but here is one reason why you should convert now, during 2010. If you convert in 2010, you can defer those taxes until 2011 and 2012 by declaring half of the “income” in each year. To get this benefit, you must convert your ROTH during 2010. After 2010, the rules require you to declare all of that income in the year you convert. Once you convert to a ROTH, all the other benefits are the same.

Of course, there are some other restrictions to conversion. The most telling is the income restrictions. If you make more than $100,000, you likely are not able to convert to a ROTH… except during 2010. In 2010, that income restriction has been lifted. This is another reason to convert during 2010 if you are impacted.

Why Open or Convert Now?

First, the sooner you convert or contribute the sooner your money is growing tax free. The more years that dollar we mentioned earlier grows the bigger it will be. Second, the special rules for 2010 may impact you. If you make more than $100,000 or are concerned about the taxes you will have to pay, the special rules for 2010 may help you.