The Best Time to Open a Roth IRA
A Roth individual retirement account (IRA) is a tax-beneficial investment vehicle allowed under the U.S. Internal Revenue Code. It is a common alternative to other tax-beneficial retirement accounts, such as 401(k) plans and traditional IRAs. It is generally best to open and contribute to a Roth IRA when your individual marginal income is lower than it will be at the time of distribution.
Other People Are Reading
-
Traditional IRAs and 401(k) Plans
-
Traditional IRAs and 401(k) plans allow the taxpayer a deduction from gross income on her individual income tax return, in the amount of the account contribution for that year. All investments in the plan then grow tax-deferred. At retirement, distributions from traditional IRAs and 401(k) plans are subject to inclusion in gross income in the year of distribution.
Roth IRAs
-
Unlike traditional IRAs and 401(k) plans, Roth IRAs offer no tax benefit for contributions to the account. Instead, taxpayers must make contributions with income that the IRS has already taxed. All investments in Roth IRAs then grow completely tax-free. The most significant difference from traditional plans is that no tax applies to qualified distributions at the time of distribution. Qualified distributions typically require the account holders to be 59 and a half or older, and to have held the Roth IRA for a minimum of 5 years.
-
Timing
-
Because traditional IRAs and 401(k) plans offer a deduction at the time of contribution, and Roth IRAs do not result in taxable income at the time of qualified distribution, most taxpayers will prefer to open and contribute to Roth IRAs when the tax rate at the time of contribution will be less than the tax rate at the time of distribution. This can be tricky, since it requires a forecast of future tax rates. In general, however, people prefer to contribute to Roth IRAs during years in which they have lower taxable earnings. Often, this includes young professionals who have not yet reached their peak earning potential (and the higher marginal tax brackets that generally go with it).
Penalties and Income Inclusion
-
Non-qualified distributions from traditional IRAs, 401(k) plans and Roth IRAs are subject to tax penalties of up to 10 percent. Non-qualified distributions from traditional IRAs and 401(k) plans are also subject to inclusion in the account holder's income for the year of distribution. However, because taxpayers make Roth IRA contributions with post-tax dollars, they do not have to include the amount of non-qualified distributions in their income for the year of distribution. Because this allows the account holder greater control of taxable income in the event of a forced distribution, some investors prefer to make Roth IRA contributions regardless of existing and future tax rates.
-
