The key feature of a Roth is this: Your retirement dollars grow and can be withdrawn tax free, as long as you abide by the rules. You can only deposit after-tax money into a Roth, and generally you can't touch your cash without penalty until you are 59½ years old. Know too, that you have to wait five years before withdrawing money for any purpose. "There are exceptions, but the rules can be complex," says Scott Cramer, president of financial advising firm Cramer & Rauchegger. "Ask your financial adviser."
Beyond those basics, there are all sorts of myths and misunderstandings about this tax-advantaged savings vehicle, some of which stem from the fact that there is also a Traditional IRA, with its own set of rules and requirements.
So to sort fact from fiction, here's what you need to know.
When you convert a Traditional IRA to a Roth IRA, and use a distribution from the Traditional IRA to pay the income taxes due, that money used to pay the taxes will count as ordinary taxable income for you. If you're younger than 59½, the distribution used to pay the taxes may be subject to a 10% excise tax for premature withdrawal, explains Mickey Cargile, founder and managing partner of WNB Private Client Services and Cargile Investments.
Also, you'll have to take your Required Minimum Distribution (RMD) in the year you convert.
If your Traditional IRA is subject to an RMD, when you convert it to a Roth IRA, you must take your annual RMD before the conversion. The RMD is not eligible for conversion. Failure to follow this rule will result in a 50% excise tax on the RMD amount, plus penalties for over-contribution to the Roth, says Cargile.
Some people also don't realize that conversions can be broken into multiple pieces, or done gradually over time. Plus, they can be reversed for a period of time, that can reach almost two years in some cases, according to Paul Jacobs, a certified financial planner with Palisade Hudson Financial Group.
The decision of whether or not to convert a Traditional IRA to a Roth IRA is not always a simple one -- much depends on your tax bracket status. Many people in higher tax brackets (or whose tax brackets are going up) would generally want to convert a Traditional IRA to a Roth IRA. By contrast, those whose tax brackets may be decreasing might benefit from keeping their savings in a traditional account, says John Liu, CEO of online brokerage Firstrade.
An Overlooked Benefit
An often-overlooked benefit of the Roth IRA is that the tax free distributions from the account don't count against income in the calculation of taxable Social Security benefits. Social Security recipients in the right income level may benefit from reduced taxes on Social Security benefits by converting their Traditional IRAs -- which are subject to taxable RMDs -- to Roth IRAs that don't require distributions and do have qualified tax-free distributions, says Cargile.
Don't Wait to Roll Over Your 401(k)
After-tax dollars in your 401(k) plan can be rolled directly to a Roth IRA with no tax consequences. "It's a mistake to not roll over those after-tax dollars from your 401(k) plan into a Roth immediately. Dollars growing tax deferred could be growing tax free," says Blumenthal.
Rate of Return Isn't Set in Stone
Many people believe that you get a specified rate of return from a Roth IRA and try to find the best rates out there. This is a misconception: Roth's aren't like CDs, where the return is pre-defined, explains Philip Liberatore, certified public accountant and founder and director of IRS Problem Solvers. A Roth is just a type of investment account, and its actual return depends on the performance of the investments used within it.
Where's My Deduction?
People often get Roth IRAs confused with the Traditional IRA, which gives investors a tax deduction today. "People often lose sight of how useful that can be and are disappointed to learn that they do not get that with a Roth IRA," says James Kennedy, a financial adviser with Kennedy Financial Strategies.
Seniors Can Play Too
Older people often think that they are past the age to contribute to their IRA. Roth IRAs, though, differ from all other tax-deferred retirement plans in that they have no mandated age at which you have to start taking distributions, so you can continue to contribute after you are 70½.
Yes, There Are Limits
You can't save any amount that you want. The IRS allows a maximum contribution of $5,000 per year, plus an additional $1,000 "catch-up" for people over 50. Contributions can only be made if you have earned income that year, notes Rob Conderman of Angelo Planning Group, because only earned income can be contributed to a Roth.
There are also maximum income limits on the Roth IRA: If you earn too much, you can't contribute. But that income limitation for Roth IRAs is applied at year end, not at the time of contribution. "So if you exceed the income limitation at year end (unexpectedly), and have contributed to the Roth, you must get the contribution out, or pay a penalty of 6%," says Timothy Gagnon, assistant academic specialist of accounting at Northeastern University.
And while there are income limits on the Roth IRA, anyone can contribute to a Roth 401(k) plan. "Don't forget to ask your employer if there's a Roth 401(k)," recommends James Carroll, president of Financial Advisors of Southwest Florida. "More and more 401ks are including the Roth 401(k)." Be aware, however, that with a Roth 401(k), mandatory withdrawals kick in when you're 70½.
No RMDs ... For You
Unlike some other investments, there are no Required Minimum Distributions during the original owner's lifetime with the Roth IRA. But inherited Roth accounts are subject to beneficiary RMD rules.
Few things in life are free, but you don't have to worry about Uncle Sam shaking you down for taxes in retirement when you tap the cash from your Roth IRA -- that alone might make a Roth ideal for part of your stash.