Given the tax-free distributions from Roth IRAs, one is tempted to stuff every penny possible into one. Alas, the IRS isn’t particularly keen on such an approach.
The Roth IRA is a very effective tool in a life long financial planning process. It is structured in a manner that allows it to accumulate a great deal of investment earnings during your lifetime and then allows you to withdraw these earnings after retirement without having them subject to income tax. The money contributed to the plan is taxed before it is deposited and so it is not subject to additional tax.
The only drawback to this is the cap put on contributions. Roth IRA caps are set at $4000 per year maximum for people under the age of 50. People above the age of 50 can contribute an additional $1000 per year for a total of $5000. These figures will increase to $5000 and $6000 per year in 2008. After that they will increase yearly in $500 dollar increments based on the yearly inflation rate.
These caps on contributions are really only a problem for people who receive a large lump sum amount of cash in a given year and desire to put a large portion of it into a tax sheltered account for investment purposes. This is very likely the reason for the cap in the first place. The Individual Retirement Account was not intended for that kind of investment tax shelter. It was designed to provide supplemental income for life after retirement.
A few calculations illustrate this point. The maximum contribution in 2008 of $5000 equals about $416 per month or a little over $100 per week. When seen this way, the figure does not seem overly restrictive to wage earners who are just beginning their careers. Assuming that a person opens a Roth IRA at age 21 and makes the maximum contribution each year until age 65, there will be a tidy sum invested. Of course, the account owner can never go over the qualifying income level and not make any early withdrawals. Also, it would assume that the inflation rate does not rise which is highly unlikely.
The above example would mean that the worker would contribute $5000 a year for 28 years or when they reach the age of 49. They would also contribute $6000 for another 15 years until age 65. This would yield a total of $230,000 in pre-taxed contributions. The investment earnings of this much capital, even when invested in safe low yield investments, for that many years would be staggering. The bottom line is that the contribution caps are annoying, but not a critical flaw of the Roth.
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IRA information at UFCAmerica.com.
