How a Roth IRA Could Make You Rich

Photo: WisDoc

For more than 10 years, a unique investment vehicle has given some people the chance to accumulate huge amounts of wealth. But until January of this year, many others didn’t have access to what may prove to be the most important investing tool you’ll ever find.

That tool is the Roth IRA, and although the name suggests that the Roth is primarily a method to invest for your retirement, it is flexible enough to serve a number of other purposes as well. From giving you a way to save for shorter-term goals to protecting your assets for future generations to come, the Roth IRA is so valuable that you won’t want to miss out on the chance to use it in your own financial planning.

Let’s take a closer look at exactly what the Roth can do for you — and why it’s getting so much attention right now.

What makes Roths great

Right now, it’s hard to remember when financial innovation didn’t automatically conjure up feelings of skepticism and distrust. But back in the late 1990s, when the Roth IRA was first created, it ushered in a new way to think about saving for retirement.

Until then, retirement investing was all about tax deferral. Traditional IRAs and 401(k) plans allowed savers to set money aside for the future, giving many of them a current tax break on their contributions. In other words, the government essentially paid you back for part of what you put into a retirement account in the form of a tax deduction. Depending on your tax bracket, that deduction could be extremely valuable as a current benefit, irrespective of whether saving for retirement was your primary goal.

The trade-off, though, was that when you actually used the money, you had to pay taxes on what you took out. From one perspective, then, the U.S. government shared in your investment gains and losses. If your IRA skyrocketed in value, then the IRS would collect more tax. Just look at some of these examples:

Source: Yahoo! Finance. Assumes taxpayer is in top current tax bracket of 35%. Prices from January 1990 to January 2010.

Those tax figures represent a darn good return for the U.S. Treasury, especially when you consider that the upfront deduction on the original $2,000 only cost them $660 or less in tax revenue.

The Roth IRA turned that logic on its end. Rather than giving you a current incentive to save, the Roth pushed the incentive far into the future by making all the growth within your account tax-free. And if you decide to convert an existing traditional IRA into a Roth, then it’s even more obvious that the Roth is a different animal than traditional retirement accounts — because you have to pay tax on the amount you convert.

Opening the door

Until now, though, many investors have been locked out of the Roth IRA. Income limitations prevent many high-income investors from using a Roth IRA, either through annual contributions or by converting existing IRAs to Roths.

Now, though, those income limits on Roth conversions have disappeared. And although high-income earners may still not be able to make their $5,000 annual contribution to a Roth, anyone who has a traditional IRA can choose to convert now.

So the big thing that everyone’s asking right now is this: Should you convert to a Roth?

For the answer to this question, read our story Understanding Roth IRA Conversions.

This article was originally published as The Roth: An Amazing Opportunity on Fool.com