Why Investing up to the 2011 Roth Ira Contribution Limit is a Good Idea

No one likes to pay taxes. A Roth Individual Retirement Account (IRA) is one of your best legal ways to avoid paying them.

A Roth IRA is a tax-friendly retirement savings plan which allows designated Roth contributions to the account. Unlike standard IRA contributions, which are pre-tax, designated Roth contributions are included in gross income.

As a result, after paying tax on the original contributions, Roth IRAs allow you to earn interest and investment income on your Roth contributions, completely tax-free. This has the potential to let you earn a very large amount of tax-free income while making only a small tax payment on the principal.

At a modest compound interest rate of just five percent, you can double your investment in just 14.2 years. Every 14.2 years, your investment will double again. If you start investing when you are 20 years old, your original investment will have grown to eight times its original size by the time you reach age 63. If you manage to get 10 percent throughout, your original investment will have grown to 64 times its original size!

For 2011, the maximum amount which may be contributed to a Roth IRA per year is your earned income or $5,000, whichever is lower. If you are 50 years of age or older at the end of the tax year, you are also allowed an additional $1,000 in catch-up contributions. If you do not use the full amount of your IRA contribution limit in 2011, the difference does not carry over into 2012.

Investing up to the maximum amount possible each year and leaving it untouched for as many years as possible will get you the best benefit out of your Roth IRA. Let’s say you are 20 years old, and you invest the 2011 Roth IRA contribution limit of $5,000. You will pay taxes on that $5,000, but after that, all the interest is tax-free. At just five percent interest, you will have earned over $35,000 of tax-free income by the time you are 63 years old, and that’s just on your 2011 contribution.

These contribution limits are over and above the contribution limits for a 401(k). You may hold both an IRA and a 401(k) at the same time, and contribute the maximum amount to each. Only the withdrawals from your 401(k) will be taxable, so your Roth IRA earnings won’t push you into a higher tax bracket.

All contributions to your Roth IRA do not have to be added into the account in one lump sum. Instead, you might choose to divide your contribution into smaller payments over the course of the year. However, you get the best benefit out of your Roth IRA if you pay into it at the beginning of the tax year, because you get nearly a year’s head start on earning tax-free interest.

Funds in a Roth IRA must be kept in the plan for a minimum of five consecutive tax years. Qualified distributions can begin anytime after you are 59-1/2 years old, provided the five year seasoning period has passed. You are also eligible for qualified distributions from his Roth IRA if you become disabled.