The Roth IRA -- named after the late Delaware Sen. William V. Roth, who was its chief legislative sponsor when it was introduced in 1997 -- is a type of individual retirement account that offers you a way to save for retirement while shielding some of your money from taxation.
Like other kinds of retirement accounts, it's up to you how to invest the money you squirrel away inside of it, whether in stocks, mutual funds, bonds, CDs, ETFs or other types of investments. But it's what's on the outside -- the Roth IRA account features themselves that makes it worth considering as a parking spot for your long-term savings.
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How a Roth IRA worksIn technical terms, the Roth IRA is a "tax-exempt" retirement savings account. That tax exemption means that you're not required to pay taxes on the investments in your account not as they grow, and not when you withdraw the funds years later to use to pay for your glorious retirement.
Yes, you read that correctly: You get to make a clean getaway with your dough without paying $0.01 in taxes as long as you follow all the rules, which we'll get into in just a moment.
Why is Uncle Sam being so generous? Because he gets his cut before you even fund your account. While other types of IRAs allow you to deduct from your taxes some or all of your contributions, it's different with the Roth. Roth contributions are never deductible. Essentially, you're using already-taxed, or post-tax, dollars to buy yourself a tax break later on.
Tax-deferred vs. tax-exemptIt's when you compare the tax-exempt Roth IRA to its similar-but-definitely different "tax-deferred" buddy, the traditional IRA, that you get a sense of how these terms play out in real life.
Let's say you made $30,000 during the year, and you put $5,500 of it into a Traditional IRA. Here's tax-deferral in action:
- First, you don't have to pay taxes on the $5,500 IRA contribution.
- And then, because you've lowered your taxable income for the year by $5,500, you'll pay income tax only on $24,500 of the $30,000 you earned. (Over time, that adds up: Funnel $5,500 into a traditional IRA for 25 years, and you've shielded a total of $137,500 in income from taxation while it grows.)
- Years later, when you start taking money out of the account for retirement, those taxes that you deferred come due. As you make withdrawals, you'll pay taxes on both your contributions and earnings at your ordinary income tax rate.
Now, here's the same scene told from the angle of the investor who used a Roth IRA: You made $30,000 during the year, and you put $5,500 of it into a Roth IRA. Tax-exemption unfolds like this:
- You do have to pay your ordinary income tax rate on the $5,500 Roth IRA contribution.
- And because you're not allowed to deduct the amount of the contribution from your taxes, you'll pay taxes on the full $30,000 you made. But if you hold tight, your tax break will come because...
- Years later when you start taking money out of your Roth account for retirement, you owe the IRS nothing -- Zippo! Nada! while your neighbors with traditional IRAs at the Golden Springs Sunset Meadows Retirement Community are required to pony up and pay Uncle Sam income taxes on their withdrawals.
Other things to know about the Roth IRA
- Contribution limits are the same as they are for a traditional IRA: As tempting as it may be to stash all of your long-term savings into a Roth or traditional IRA, there are limits to how much you can contribute. In 2015, the maximum contribution limit is $5,500, if you're under the age of 49. However, taxpayers who are age 50 and over can sock away $6,500. The extra $1,000 is what's known as a "catch-up contribution" and gives you something to gloat about when you turn the big 5-0.
- Age is not a factor: Unlike the ageist traditional IRA -- which requires you to start making required minimum withdrawals, or RMDs, and cease making contributions at age 70-1/2 -- you can contribute to a Roth IRA well after you blow out the candles on your 72ndbirthday cake. Plus, you can leave your money in a Roth IRA for as long as you live.
- The Roth allows you access to your principal penalty free before age 59-1/2: It behooves us all to leave our retirement money alone so it can grow as long as possible, or at least until age 59-1/2, when the IRS allows you to withdraw money from the account without socking you with a 10% early withdrawal penalty. However, the Roth offers a few workarounds if you absolutely need access to your money before then:
- You're allowed to withdraw your Roth IRA contributions (the principal) penalty free and without paying income taxes on the amount at any time, as long as the money you are taking out has been in the account for at least five years. (If you withdraw earnings --your gains -- from a Roth IRA before age 59-1/2, regardless of the five-year holding period requirement, you'll still have to pay the 10% early withdrawal penalty.)
- With a traditional IRA, both contributions and earnings are subject to the 10% early withdrawal penalty. On top of that, traditional IRA early withdrawals are taxed as income.
- You can raid your Roth earnings to help pay for certain expenses: As long as the money has been in the Roth IRA for at least five tax years, first-time homebuyers can pull out $10,000 in profits penalty free and tax free. Withdrawals for qualified education spending are also allowed, and can be made without incurring penalties. Same goes for withdrawals if you become disabled, or if you use the money to pay for unreimbursed medical expenses and health insurance if you are unemployed.
If that all sounds great to you, let's see if you're a good candidate for a Roth IRA.
Are you eligible for a Roth IRA?In order to contribute to a Roth IRA, you must meet certain criteria.
- You must have received taxable compensation -- e.g. self-employment wages, salaries, fees, tips, bonuses, commissions, taxable alimony -- in the year in which you are contributing to a Roth IRA.
- Unlike the traditional IRA, which has no income restrictions on eligibility to contribute, your income and filing status may limit -- or entirely eliminate -- your ability to contribute to a Roth IRA.
That last point's the stickler, and the issue that removes the Roth IRA from the realm of retirement account choices for a lot of folks. To see if you can contribute to a Roth, check out this table:
2015 Roth IRA Contribution Limits
Final considerations about whether to Roth or notIf you qualify to contribute to a Roth IRA, deciding whether or not it's the right account for you is essentially a question of when you want a tax break. Would you rather pay more in taxes today in exchange for lower taxes in retirement? That certainly makes sense if you think you'll be in a higher tax bracket in the future.
If your crystal ball is broken, and you're not sure which tax bracket is in your future, then start weighing the other features offered by the Roth -- the ability to make contributions after age 70-1/2, the freedom to choose when you start making withdrawals, and the flexibility of dipping into your contributions early and penalty free. Consider a few different scenarios, tinker with our Roth IRA calculators,and take the time to weigh your options.
The article What Is a Roth IRA? originally appeared on Fool.com.
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