You need a Roth Individual Retirement Account (IRA).
Even if you're taking advantage of a 401(k) savings program at work, putting away additional money in a Roth account can help you reach financial independence.
Like a 401(k) account, your contributions grow tax-deferred, but Roths have an added bonus: Withdrawals from Roths are tax-free.
Here's how you can make Roth IRAs an invaluable part of your retirement savings plan.
How Roths Work
A Roth IRA, like your 401(k), is a tax shelter for retirement savings. Roth rules differ, though, from your workplace plan. You can save $5,000 in 2010 to a Roth account, and if you're over age 50, you can save an extra $1,000--the so-called "catch-up contribution." You can then invest in stocks, bonds or mutual funds within the Roth.
If you earn too much, you may not qualify for a Roth. Check this IRS chart to see if you qualify.
The big difference between a Roth IRA and your 401(k) is that your 401(k) allows you to lower your taxable income for the year by the amount of your contributions. Same goes for traditional IRAs if you fall within certain income limits. When you withdraw funds from a 401(k) or traditional IRA, the funds are taxed as ordinary income. With a Roth, you give up today's deduction in favor of tax-free withdrawals when you retire.
Another big difference: Traditional IRAs and 401(k) accounts require you to take withdrawals, called Required Minimum Distributions, or RMDs, after age 70 1/2. (You have to take out those funds whether you need the money or not.)
But Roths have no withdrawal timetable.
"There's more flexibility to take out what you want when you need it in retirement--you're not forced to take out more than you need, pay tax on it and then invest the net in a taxable account," says Cynthia Turoski, a certified financial planner and certified public accountant with Bonadio Wealth Advisors in Albany, N.Y.
Your Roth and Your 401(k)
You should weigh all of your savings opportunities.
If you have a 401(k), 403(b) or other retirement plan at work, you can still contribute to a Roth (if you meet income limitations), and indeed, many advisors say it's smart to do both. Here's why: When you take funds from your work retirement plan, you'll be taxed on those withdrawals. Same goes for withdrawals from a traditional IRA. That could mean a big tax bill when you start taking distributions from the plans.
"Their potential distributions, if they continue investing in traditional vehicles, will be huge, especially if ordinary income taxes increase, which they probably will," says Michael Gibney, a certified financial planner with Highland Financial Advisors in Riverdale, N.J.
If you think tax rates will rise, the tax-free withdrawals and a lack of required withdrawals from a Roth will be that much more valuable.
That doesn't mean you should stop your 401(k) contributions in favor of the Roth. You can do both.
Turoski recommends that investors prioritize their retirement savings contributions. If your employer offers matching funds, absolutely contribute enough to get the full match. Next, if you qualify, do the Roth. If you still have money available to invest, max out your 401(k) contributions.
The Conversion Question
If you already have a traditional IRA but you think a Roth suits you better, you can make a change known as a Roth IRA conversion.
This is an especially hot topic in 2010, which is something of a bonus year for high-income individuals. In years prior, investors could only convert a traditional IRA to a Roth IRA if they met certain income requirements. For 2010, those requirements are lifted, so any investor can make the conversion. The IRS even allows you to spread the tax bill over two years.
Here's how it works: You tell the financial institution that you'd like to convert your traditional IRA to a Roth. You essentially withdraw the IRA funds now, pay the taxes due, and then you reinvest the funds in a Roth.
So you can make the conversion, but should you?
That depends. If you are many years away from taking withdrawals, it could be a good move, especially if future tax rates rise. But you'll still have to find cash to pay the conversion tax bill.
"If you're young and can afford to pay the conversion tax from outside money without jeopardizing your cash position, it's usually a slam dunk to convert," Turoski says. "You would essentially be freezing the value of your IRA account for income tax purposes. All future growth could escape taxes."
If you don't have cash available to pay the tax, some investors choose to pay the tax out of IRA proceeds. That's not usually a good idea. You'll lower the balance of your retirement account and lose out on more tax-deferred growth. Plus, if you have to take money from the IRA to pay the conversion tax and are under age 59 ½, the withdrawal for taxes would be subject to a 10 percent premature distribution penalty on top of the income tax.
If you don't think you'll need withdrawals from the IRA for living expenses, a conversion to a Roth can be a great estate planning tool. The Roth would be passed to your beneficiaries free of tax, forever.
But if retirement is close and you may start taking withdrawals in a few short years, paying the tax now may not make sense.
To see if a conversion might be right for you, try this calculator.
Other Considerations
Roths have some other features you won't find with your 401(k) or traditional IRA accounts. You may take early withdrawals without a penalty, even if you're under age 59 1/2, for certain expenses, such as significant unreimbursed medical expenses, health insurance premiums if you've lost your job, or a down payment for a home, if you're a first-time buyer. See the complete list of exceptions here.
While these features may give you flexibility if you need cash, remember: Any money you withdraw now means less for your retirement.
"While it may be appealing to use this distribution for a first-time home purchase, it may not be the best use," says Gibney. "It's a similar argument to the one against 401(k) loans, and you are borrowing against your retirement nest egg. You make these contributions for retirement, not for other reasons."