Own Your Retirement: Roth IRA Basics

Welcome back to my series of posts on the basics of saving for retirement. The previous post was about traditional IRAs, which are the most basic way that Americans can set aside money for their golden years. Today we’re going to explore the Roth IRA, which is a newer way to save. Traditional and Roth IRAs have some similarities as well as important differences, so you may want to bookmark both posts to compare and contrast them as you decide which is best for you.

What Is a Roth IRA?

A Roth IRA is a type of Individual Retirement Account that Americans can use to set aside money for retirement. Like a traditional IRA, the Roth has tax advantages that allow your money to grow faster because you don’t have to pay taxes on growth and dividends. However, the timing of the tax benefits differs.

When you contribute to a Roth IRA, you are putting in money that you’ve already paid income taxes on. The advantage of the Roth is that you will never have to pay taxes on that money again. When you retire, you can take tax-free distributions, and the money can grow for as long as you like.

Note that this is different from the traditional IRA, in which money isn’t taxed until you take it out of your account when you retire. Both accounts have tax benefits; it’s simply a matter of when you receive them.

Roth IRA Rules

Roth IRAs have very generous tax benefits, but they are also subject to specific rules and regulations. Here’s what you need to know:

  • For people under age 50, you can only invest $6,000 per year.
  • For people over age 50, you can invest $7,000 per year.
  • You can continue to invest at any age, as long as you had earned income that year.
  • You are free to withdraw the amount of your original contributions at any time, with no tax or penalty.
  • After age 59 1/2, you may withdraw your contributions as well as your earnings without penalty.
  • If you withdraw earnings before age 59 1/2, you’ll pay a 10% penalty on the amount you take out early.
  • You must have an Adjusted Gross Income of $137,000 or less if you’re single or $203,000 or less if you’re married in order to contribute to a Roth IRA.

It pays to invest early in a Roth IRA, since you must own the account for five years before you can withdraw earnings from it. But remember, you’re always free to withdraw your original contributions, which makes a Roth IRA a good back-up plan in an emergency as well.

The Benefits of Roth IRAs

  • A Roth IRA is never taxed, so it’s a good way to keep your taxes lower during retirement, when you’re on a fixed income.
  • Likewise, the Roth’s tax-free status allows your money to compound and grow faster, since you won’t be losing any to taxes over the years.
  • There is no age at which you must take distributions, so you can keep your money invested well after age 70.
  • If you end up not using all of the money in your Roth IRA, you can pass it down to your heirs upon your death — and they won’t have to pay taxes on growth or distributions, either.

The Drawbacks of Roth IRAs

  • Roth IRAs won’t help lower your tax burden right now, since you pay taxes on your money up front.
  • Income limits may shut you out of your Roth as you reach your peak earning years.
  • You may end up paying more in taxes on your money now than you would in retirement, when most people have less income and are therefore in a lower tax bracket.

When deciding between a traditional and a Roth IRA, your biggest consideration is whether you need the tax break now or later. Many people find it worthwhile to hedge their bets and split their contributions between a traditional and Roth IRA. If you choose to open both, your contribution limit needs to be split between the two accounts.

Looking for more advice on investing? Check back for more to come in this series about retirement, or sign up for a Brainy Money course to sharpen your personal finance skills today.

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