What Exactly is a Roth IRA?
A Roth IRA is a type of individual retirement account that has a particular tax benefit that no other individual retirement account can offer. Most of the time, people who do not have retirement plans through their employer (such as a 401(k)) will opt for either an IRA or a Roth IRA as their primary retirement planning/savings tool. A Roth IRA can be attractive because unlike a traditional IRA, you fund the Roth with contributions on which you have already paid income tax, thus not having to pay taxes later on what you withdraw at the time of retirement.
On the other hand, a traditional IRA is considered a tax-deferred program — while you do not have to pay taxes on the money you contribute to the IRA now, it will be taxed at the time of withdrawal, at whatever tax bracket you are in at retirement age. The allure of these traditional IRAs has always been that you will pay less tax at the time of retirement because you will supposedly be in a lower tax bracket. But that may not necessarily be the case. A Roth becomes more attractive as you consider that all of the money you put into it is entirely your cash (not tax subsidies) so you can withdraw your contributions (but not earnings) at any time without having to worry about any taxes or penalties. At the time of retirement, when it comes time to withdraw, you will be able to receive your money tax-free, both all that you contributed and the growth the account has accrued over the years. A Roth IRA taxes the “seed” but an IRA taxes the “crop.” Ask yourself, does it make more sense for me to be taxed on the seed or the crop? The answer will depend on your current circumstance.
Roth IRAs are generally a sensible option if you believe your tax rate is going to be higher while you are retired than your current rate. So, for example, a young worker who isn’t making a large income is the perfect candidate for a Roth IRA. He or she isn’t nearly as likely as someone older to miss the upfront tax deduction that comes with standard IRA contributions, and they will benefit from many years of compounded growth completely free of taxes. Older, wealthier taxpayers looking for a tax-free vehicle to help them leave money to their heirs tax-free would also be wise to look into Roth IRAs, as would anyone who simply wants to minimize the tax hit they take in retirement from their accounts.
Are you eligible for a Roth IRA? There are a few limitations. As of 2014, here are some of the eligibility standards:
- You can contribute $5,500 annually (or $6,500 if older than 50) if you are single or the head of a household and you have a modified adjusted gross income of under $114,000.
- If you are married filing jointly, you can contribute the maximum amount to a Roth IRA if your income is under $181,000.
- You can make partial contributions if you are single with an income between $114,000 and $129,000 or if married and have an income between $181,000 and $191,000.
For more information about Roth IRAs as retirement planning and savings tools, contact us today at Money Mastery.