Generation X and the Roth IRA—A Perfect Match

It’s not often that earning less is an advantage in the working world but one of the savviest things a young person can do right now is invest in a Roth IRA. You can contribute up to $5,000 a year in after- tax earned income, twice that if you’re married. If you’re 25 now and sock away the maximum at 8% a year, you end up with $1.1 million at retirement and it’s all tax-free. Double that number if your spouse does the same thing.

So where’s the catch? For one thing, you can’t claim a tax deduction like you can with a traditional IRA contribution. Second, you can’t contribute if you make more than $95,000 a year ($160,000 if married and filing jointly). Old guys like me usually don’t qualify because our income climbs as we grow older and gather more experience. Younger Xers also have more time on their side when it comes to savings.

So which is better for you if you’re on the cusp, traditional or Roth? If you’re still young and expect to earn more in the future it makes more sense to invest in a Roth because the money you contribute now will be taxed at a lower rate. As you grow older your income will grow as will your tax rate. Think of it like spring planting season. With the Roth, the small seed you plant is taxed now but the harvest will be tax-free providing you follow the rules.

You have to keep the money in a Roth for five years before it qualifies as tax-free. Like a traditional IRA, money withdrawn before age 59 1/2 is subject to a 10% tax penalty. But unlike a traditional retirement account, the minimum distribution requirement doesn’t apply that means you don’t have to start taking money out at age 70 ½. You can also withdraw funds in an emergency after the five- year period, tax-free, although you still pay the 10% penalty if you’re younger than 59 ½.

What about the Baby Boomers, is it too late for us to utilize the Roth? Not necessarily, especially if you believe, as I do, that tax rates, including the minimum tax, in this country will continue to rise. Washington’s legacy of spending, budget deficits and the long-term funding needs of social security make future tax increases inevitable.

I still have clients, well past sixty, who religiously contribute to their Roths. Some work part-time and now qualify to contribute for the first time since the Roth was enacted as part of the Taxpayer Relief Act of 1997. Other retirees are converting their traditional IRAs into Roths to lower their tax bills or because it makes sense as part of an overall estate planning strategy.

One final benefit: if you open a Roth IRA before the mid April deadline and make a contribution for the year 2006, you will only have four more years to go before it’s all tax-free.

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