The Roth IRA is not only one of the best investment vehicles out there, but you could also make the argument that it is one of the best pieces of legislature ever passed by Congress.   William Roth, a Senator from Delaware helped sponsor the bill that created the Roth IRA in 1997.    As most people are familiar with the basics of how a Roth IRA can be used for Retirement Planning , this article focuses on three uses of the Roth IRA that most people have not considered but are useful tools to build wealth, especially in the current economic environment.  This economic environment is special with respect to a Roth IRA because of the fact that stock and mutual fund prices have decreased over the past year and a half, making the taxes paid on a Roth IRA conversion a lot less than if stocks and mutual funds have been increasing.   The other thing that makes a Roth worth looking into is the fact that federal and state tax rates are at historic lows.  Our Government handing out billions and billions of dollars means only one thing for the future: increased taxes.  When converting or creating a Roth you are essentially using money that has already been taxed with the benefit of never having to pay tax again on the earnings or when you withdraw it.

When some people with high incomes hear about the Roth IRA they automatically tune out because there are income limitations that one can have to use a Roth IRA.  Put simply, the government says if you make too much money you are not allowed to contribute to a Roth.  Please continue to read this article because not only are the Roth income limitations set to expire in 2010, but some of the techniques I discuss can be used irrelevant of any income.

Basics of a Roth

To understand why the Roth IRA is such a good idea, we need to first define what the Roth IRA is and how it is different from other retirement or investment accounts.   At a high level when you open a Roth account and contribute to it, you are using money that has already been taxed (after you receive your paycheck).  Once the money goes into the Roth account it will never be taxed again.  It grows tax free year after year and when you take distributions from the account you will also not be taxed on it.  If we compare this to a traditional IRA or 401k/403b account it is slightly different.  With those types of accounts the money is contributed to your account on a pre-tax basis.  Your account will still grow tax-free however when you take distributions from a traditional IRA, or 401k/403b account you will be taxed on the money.  Conversely if you open up a traditional brokerage account, your contributions would be made using post-tax money, and you would have to pay taxes every year on your capital gains and any income that your investments earned.

Other uses for a Roth

The following are three examples of additional ways a Roth can help in Wealth Creation

Education Planning

When most people think of saving for a child or grandchild's education they turn to a 529 Plan or Coverdell IRA account.  The Roth IRA is another great option that can help in education planning.   The benefits of incorporating the Roth into your Education strategy is that compared to the 529 plan it offers more flexibility as well as lower costs.  You can withdraw your Roth IRA dollars, penalty-free to pay for a qualified higher-education expense for you, your spouse, your child, or grandchild.  Qualified expenses include tuition, fees, books, supplies and equipment.  The 529 plan limits what you can use the money for.  An added benefit is that if your child decides not to go to college if the money is in a Roth there are no problems, it can continue to grow tax-free.   If it is in a 529 plan or an Educational IRA, you can find someone else to use it for higher learning, but it must be used to pay for education.

Childs Retirement Planning

This use case for the Roth IRA will demonstrate the power that compounding has on generating weatlh.  Anyone who has earned income can contribute to a Roth IRA.  The IRS states that an individual as young as 7 years old can have a job.  Instead of your son or daughter spending their money on baseball cards or video games, they can contribute to a Roth IRA and secure their retirement as early as possible.  The following table shows what would happen if your child started saving $5000 per year and earning 7% on the money.

Having five million dollars when they retire at age 70 is not a bad scenario.  To utilize this strategy it is necessary that you hire your child formally and have the proper documentation (W-2's) filed every year.  Note: It is advisable to talk to your accountant regarding the proper process of hiring your child.

Estate Planning

Retirees with IRA's usually fall into two categories

1.  They tap their IRA's for living expenses
2. They take only required minimum distributions from their IRA's because they have other sources of retirement income

A Roth conversion may make sense in either of these cases to provide a larger inheritance to their beneficiary.  There are horror stories regarding Uncle Sam collection as much as 90% of people's estate.  By executing a Roth conversion you are increasing the ability of your money to grow tax-free and therefore having the ability to pass more of it on.

The following example can help illustrate how this can be done:

Bob, is a 75 year old widow with ample net worth.  He has a 100,000 IRA from which he has been taking RMDs.  The IRA's sole beneficiary is Bob's daughter Sarah, a 50 year old lawyer.  Bob plans to continue withdrawing the minimum required amount leaving Sarah a sizable inheritance.  

Assuming Sarah inherits this IRA, she will have to take RMDs and pay income tax on those distributions at her higher income tax rate.  If Bob is in a 15% tax bracket, converting his traditional IRA to a Roth would cost him $15,000.  After the conversion he would not have to take any RMDs from her Roth and it could then grow tax and distribution free.  Even if Bob does not want to pay the $15,000, it may make sense to continue with the conversion and have Sarah fund it.  The benefits to Sarah (tax-free income in the future) would probably far outweigh any initial and supplemental costs.

Conclusion

Not only is the Roth IRA great to use for planning for your retirement, but there are other areas that make it an extremely useful tool.  The cards are stacked against the individual investor, from Uncle Sam wanting to get his hands on everyone's money to Financial Institutions taking advantage of the everyday investor, to corporations going bankrupt wiping out people's retirement plans. 

The following are some of the areas where Bautis Financial has helped clients achieve their financial objectives over the past couple of months:

• Developed a retirement plan for a lady in her 60's who wanted to see what her monthly income would be during retirement.  I took an inventory of her assets in addition to the lifestyle she wanted to live in retirement and not only constructed a portfolio but laid out a plan of how to take distributions from those assets during retirement.  

• Helped a Small Business owner with setting up a retirement plan for his corporation and the individual accounts for his employees.  We did an analysis of the different available plans (SEP-IRA, 401K, SIMPLE IRA, ...);  the pros and cons of each one related to his business and selected one that was the best for his situation.

• Worked with an individual that lost a lot of money during the recent financial crisis and wanted a second opinion on their portfolio.  I conducted an analysis of their portfolio to help create an optimal asset allocation mix that would smooth out some of their returns and also minimize some of the high expenses they were paying on the mutual funds they owned

• Performed Education planning for a couple who recently had a baby.  We discussed the differences between using a 529 Plan, a Coverdell IRA, and other options for funding education.  We devise a strategy consisting of different investment plans to help fund their child's future education.

• Conducted a planning session with a couple in their 60's to determine when the optimal time for them to begin taking Social Security benefits.

• Discussed a tax efficient way for an elderly widow to pass money on to her heirs

• Counseled someone on their 401k retirement plan selections and discussed whether it makes sense to keep their money in a 401k plan, transfer it to an IRA, or to convert it to a Roth IRA.