Roth IRAs were created in 1997 to offer a tax advantaged way to save for retirement, apart from what you can find with a traditional IRA. Currently, roughly 22% of Americans surveyed said they have an IRA account, and while most use a traditional IRA, more and more savers are turning to a Roth IRA for their numerous benefits and advantages.
One of the main advantages of a Roth IRA is the lack of taxes paid on your principal contributions. Here, we’ll talk more about that advantage while discussing other advantages – and drawbacks – of a Roth IRA and provide insight into the tax implications of having one of these accounts.
Taxes and Roth IRAs
As you may know (especially if you have a Roth IRA), Roth IRAs have tax advantages over traditional IRAs, which have tax advantages of their own.
The main feature of a Roth IRA is that you don’t pay taxes on your withdrawals. With a traditional IRA, you don’t have to pay taxes on your contributions before you make them, but you do have to pay income tax when you withdraw these funds and their earnings from your account once you hit the age of 59 ½.
With a Roth IRA, you have to pay taxes on your money before you put it into your account, but you don’t have to pay taxes on your original contributions when you withdraw them – and you can withdraw them at any time without penalty. For example, if you contributed $10,000 in 2011, you can withdraw $10,000 whenever you like without having to pay any kind of tax on the amount.
That is one of the biggest advantages of a Roth IRA: the lack of taxes when you withdraw your original funds.
What about earnings, though? Earnings, under certain circumstances, aren’t taxed either. If your earnings – the money in your account that you’ve accumulated from your investments – is a qualified distribution, i.e. it has been in your account for at least five years and you are at last 59 ½. The money also is only tax free if it is withdrawn to one of your beneficiaries after your death, or you become disabled, or you want to pay up to $10,000 toward a first-time homebuyer’s purchase.
Any nonqualified distribution has to pay income taxes and
So, to recap:
- You have to pay taxes on your original contributions before you put them into your account. These dollars are post-tax dollars, as opposed to pre-tax ones with a traditional IRA.
- You don’t pay taxes or penalties when you withdraw your original contributions, and you can withdraw them at any time.
- You can avoid taxes and penalties if you withdraw your earnings after they’ve become qualified distributions. Otherwise, they’re subject to taxes
When Should You Choose a Roth IRA?
The tax advantages listed above are nice, especially for investors who like to invest in high-growth assets (like high-growth stocks) that appreciate rapidly and can deliver high returns. The fact that you can avoid taxes on this growth is very appealing in that situation.
Of course, you do have to pay taxes when you put in money, so your initial principal won’t grow as quickly as it will with a traditional IRA. A bigger question, though, is whether or not you should get one of these plans based off how much you make now versus how much you think you’ll make when you retire.
Let’s say that now you make $50,000 filing separately, which places you in the 25% marginal tax bracket. If you suspect that you’ll be making more income when you begin withdrawing your earnings when you turn 59 ½ (we’ll say you’re making $90,000 at that time, which is a 28% bracket), you’ll come out ahead because you’d pay more in taxes then than you do now.
If, however, you’re like many Americans and you’ll make less at retirement than you do now, it might not be to your advantage to pursue a Roth IRA. You could pay 15% on $35,000 when you retire with a traditional IRA, but instead you’ll pay 25% on $50,000 at this point in time.
Above all, consult with a tax and investment professional before you make a decision on which account you want to open. Roth IRAs can be great tax shelters, and can give you a way to keep more of your earnings and original contributions without paying as much to the tax man every year.