Roth IRA: What Is It?
A Roth IRA is a type of retirement account. This particular type of plan is an Individual Retirement Account, which means the account is not linked to any type of employer based account. Individuals who do not have a retirement account through their employer, or who would like to add additional funds to a qualified retirement plan should consider the benefits of using this particular plan.
How It Works
As a retirement account, a Roth IRA is designed to provide you with a way to put money away for the future. Keep in mind this is not a savings account. Once you put money into this type of account for the means of retirement, withdrawing from an IRA is costly because the federal government taxes it heavily if taken out early. You set up this type of account at a local financial institution. You can use a local bank, credit union or a financial investment firm to manage the IRA.
The advantage of a Roth IRA is that it the funds in this account grow tax free. Although you need to follow Roth IRA rules when investing the funds, once the money enters this account and remains there over your lifetime, it can be withdrawn during retirement without any taxes levied on it. Instead, these taxes are levied on the account prior to the funds being invested. Here is how this process works.
- Your employer pays you. You deposit your paycheck into your bank account. Your employer has taken taxes out of your paycheck already. This is taxed income then.
- The bank takes funds out of the paycheck and automatically puts it into your Roth IRA account, based on the terms you set up. You control how much of your check is deposited.
- The funds remain in the retirement account until you reach retirement age. During that time, the funds grow based on interest and other investments that the investment makes through the financial institution.
- When you retire, you are able to make Roth IRA withdrawals. These withdrawals can be used as you would like to, such as to pay for your monthly costs during retirement or even to travel the world. You do not pay taxes on these funds at the time of withdrawal.
Keep in mind that you can set up the account in various other ways. For example, a financial institution can simply withdraw a set amount of money from your paycheck each week.
Following Roth IRA Rules
This type of retirement account is federally recognized as such. Not any savings account or other investment account is the same as this particular type of account. For that reason, you will need to establish the account with a financial institution that is able to meet government guidelines for maintaining these retirement accounts.
There are additional rules to follow when making Roth IRA contributions. For example, you will need to keep the amount you deposit under the Roth IRA contribution limits. These limits do change from year to year. For tax year 2010, for example, individuals can contribute $5000 for the year into this account. If you are over 50 years of age, you can contribute $6000 this year. Check with the Internal Revenue Service to learn more about the specific guidelines for this year. If you invest more than this, the funds will be taxed heavily.
Who Is This Account Good For?
Not everyone will benefit from using this account. While you may meet the Roth IRA eligibility requirements, consider your long term financial goals before investing in this particular type of account.
For those who are earning less now than they plan to earn later in life, investing in a Roth IRA makes the most sense. This way, you are taxed on the funds now, when you are in a lower tax bracket and therefore will be taxed less in the long term. If you wish to benefit from having tax free withdrawals later in life, perhaps due to your higher income at that time, then this is the right type of account for you.
On the other hand, do consider a traditional IRA versus Roth IRA accounts. In a traditional IRA, the funds are invested prior to the funds being taxed. The funds enter the account untaxed and grow over time. They are then taxed when the funds are withdrawn from the account. This type of IRA is ideal for those who are likely to have a lower income later and therefore will be in a lower tax bracket later on.
Advantages of Roth IRA
There are advantages to Roth IRA investing. If you wish to participate in tax deferred growth for your funds, and you wish to receive tax free withdrawals later in life, this is the right type of retirement account for you. In addition, you should plan to avoid early Roth IRA withdrawals, as these can be very expensive.
If you are considering the investment in this type of retirement account, realize that you should compare options in financial institutions. Learn how the funds are invested and which type of investment portfolio is right for your needs, including your level of risk tolerance. Retirement accounts like the Roth IRA are best for those who are able to put money away without a need to access those funds in the near future so that they do not face penalties for early withdrawal of the funds.