Understanding a Roth IRA and its Advantages

A Roth IRA (Individual Retirement Account) is a popular investment and retirement vehicle for millions of Americans.  If you’re just getting started investing, you may even be considering using a Roth IRA.  However, a Roth IRA was designed by the United States Tax Code, and as a result, there are a lot of rules and nuances as to what you can and can’t do with a Roth IRA.  Here is what you need to understand about a Roth IRA.

The Basics

The basic thing about a Roth IRA is that it is just like a traditional brokerage account in that it is the vehicle in which you hold various investments.  However, since this is an account designed for retirement, there are limits on when you can withdraw the earnings from your investments.

With a Roth IRA, you invest after-tax money into the account, and in retirement (currently defined as age 59 ½), you can withdraw the earnings tax-free.  However, you can always withdraw your contributions, at any time tax-free, since the money was after-tax anyway.

The gamble with a Roth IRA is whether you will pay more taxes now or more taxes later.  For example, if you are currently taxed at 20%, but expect taxes to rise, or that you will be in a higher tax bracket in retirement, it makes sense to invest.  However, if you are in the highest 35% tax bracket now, you may not believe you will still be there in retirement, in which case it doesn’t make sense to use a Roth IRA.

The Rules

To utilize a Roth IRA, there are a lot of specific rules that need to be followed.  First, if you qualify, you can only contribute $5,000 currently (or $6,000 if you’re over age 50).  You can also only contribute up to what you earn.  So, if you only earn $1,000, that is the maximum you can contribute.

You also have to meet certain income limits to make the full contribution.  That amount is currently $110,000 for single filers, and $173,000 for joint filers.

The Advantages

The biggest advantage of the Roth IRA is the potential tax savings in retirement, since the money can be withdrawn tax-free, after both the age limit (currently 59 ½) and the seasoning period (currently 5 years) have been met.  In contrast, other securities held for long term would be subject to the current 15% capital gains tax (which may go up in the future).

The other advantage is that, unlike other retirement vehicles, there are no required distributions that need to be taken.  You can keep the money in the account and pass it on to your heirs if you don’t use it.  Also, if your spouse is the beneficiary, he or she can use it just like the original IRA was intended, and make contributions and withdraw tax-free.

If the beneficiary is not your spouse, distributions from the Roth IRA will continue to be tax-free as long as at least 5 years have elapsed before the distribution is taken.  This continues to provide tax savings even after you’re gone.

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