A Roth IRA is a type of investment account used for retirement planning. ‘IRA’ stands for ‘individual retirement account’. The Roth IRA was named after Senator William Roth, who was the chief sponsor of the Taxpayer Relief Act of 1997, which created this type of account.
Contributing Money to a Roth IRA
Contributions to a Roth IRA are not tax-deductible. Individuals can contribute as much as they want to a Roth IRA, up to a stated limit set each year by the IRS. This limit is currently $5,500, which applies to a person’s aggregate contribution to all of their IRAs.
Example: if someone had a traditional IRA and a Roth IRA, they could put, say, $3,000 in the traditional account and $2,500 in the Roth account – not $5,500 in each account.
Investors over age 50 can make “catch-up” contributions of up to $1,000 – raising their total annual contribution limit to $6,500.
Roth IRA Investment Options
There are many different investment options For Roth IRAs. Some of the most common investments include stocks, bonds, mutual funds, exchange-traded funds, and annuities.
Unlike the case with taxable brokerage accounts, in a Roth IRA, tax on dividends, interest, and capital gains is not due in the year it is realized. As we’ll explain further, if the account is utilized properly, gains can be completely tax-free.
Withdrawing Money from a Roth IRA
Under normal circumstances, withdrawals from a Roth IRA are tax-free. This includes withdrawals of contributions and associated earnings. A couple of things have to be in place in order to receive this favorable tax treatment, though.
First, the account owner must be at least age 59½ in order for their withdrawals to be tax-free. Withdrawals before this age are subject to a 10% tax penalty.
Also, contributions must have been in the account for at least five years in order to be withdrawn free of tax.
Compared with a Traditional IRA
The traditional IRA is another type of retirement planning account to which the Roth IRA is frequently compared. There are some similarities between these account types, but there are also some important differences which relate mostly to taxation.
Contributions to a traditional IRA are tax-deductible in the year they are made, while Roth contributions are not tax-deductible at all.
Withdrawals are treated differently, too. While qualifying withdrawals from a Roth IRA are tax-free, traditional IRA withdrawals are the opposite. They are fully taxable at the account owner’s ordinary income tax rate.
There’s no way to get around paying taxes on your money, but you can decide when you want to pay them. Common advice is that investors who expect to be in a higher tax bracket in retirement should choose a Roth IRA. They may save money by paying taxes on their contributions now rather than later.
Investors who are in a higher tax bracket now than they expect to be in retirement, on the other hand, may benefit from a traditional IRA. They can defer taxes for now, paying them when they expect to be taxed at a lower rate.
As with any investment decision, it’s a good idea to discuss your situation with a financial or tax advisor before making any investing or retirement planning decision.