Definition of a Roth IRA

A Roth IRA is one type of Individual Retirement Account authorized by the IRS. Roth IRAs are distinctly different from other IRAs, 401(k)s and similar plans. With most retirement plans, you receive a tax deduction for contributions. Money you invest and any earnings are taxed only when withdrawn after retirement. With a Roth IRA, there is no up-front tax deduction. But all earnings are tax free if withdrawn according to IRS rules when you retire. If a person expects to be in a higher tax bracket after retirement, this offers a substantial advantage over most other retirement plans.

Identification

Anyone can open a Roth IRA as long as they have earned income, including minors. Contributions are limited to $5,000 per year ($6,000 as of age 50) as long as the contribution does not exceed earned income. For regular distribution (withdrawal), you must be at least 59 1/2 years old and the Roth IRA must be at least five calendar years old, counting the year the account was opened.

Allowed Investments

You can use a Roth IRA to invest in CDs, money market funds, stocks, bonds and some precious metal coins issued by the U.S. Mint. Some real estate and small-business investments also qualify. Investing in collectibles (such as rare coins) and most forms of bullion other than U.S. investment coins is prohibited. You cannot use a Roth IRA to trade derivative or securities on margin.

Distributions

When distributions are made from a Roth IRA in accordance with IRS rules, all earnings are tax free. In addition, there is no mandatory distribution rule as with a traditional IRA, so you can leave the funds in the account as long as you wish. Rollovers into a Roth IRA are allowed. But any rollover funds must remain in the account for five years before they can be withdrawn.

Early Withdrawal

Because taxes have been paid on contributions to Roth IRAs, they can be withdrawn at any time. Earnings normally cannot be taken out early. Exceptions are allowed if the IRA has been inherited or if the owner of the account is disabled. Up to $10,000 can be withdrawn for the purchase or repair of a first home. If a withdrawal is made early in violation of IRS rules, a penalty tax of 10 percent of the amount withdrawn is incurred, and the money withdrawn is subject to regular taxes as well.

Ordering Rule

The IRS uses an ordering rule to decide if early withdrawals are permitted. Any distribution is assumed to be contributed money unless the total of all contributed funds is exceeded. Any further withdrawals are considered first to be rolled-over funds (if any) and only after that total is also exceeded are withdrawals considered earnings.