When Is It Worth Investing in a Roth IRA?
Any kind of savings, whether it be for retirement or any other reason, is worth it in the long run. Deferred retirement savings plans such as Roth IRAs have advantages unlike any other deferred savings account. However, there are limits to how much can be contributed and there is a gamble. The gamble is that the holder of the Roth IRA counts on the idea that tax rates are lower today than they will be when the holder retires. This is different than a traditional IRA that defers taxes today for income taxes upon retirement.
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Pay Taxes Once
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The beauty of the Roth IRA is that you only pay taxes one time -- when you earn the money in the form of wages, tips, commission or other income reported on line 2 of IRS Form W-2. Passed in the early 1990s and named for the Senator who authored the bill, the Roth IRA is designed to encouraged retirement investing in areas of the economy with higher historical returns. Like the 401k and the traditional IRA, the Roth IRA is a tax deferred savings plan for retirement. Unlike previous deferred plans, taxes are paid up front instead of upon distribution.
No Taxes on Dividends and Interest
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IRS deferred tax savings plans for retirement use tax benefits as an inducement to participate. Unlike investing in the stock market, real estate, commodities or other markets, the capital gains from these savings plans are not levied with capital gains taxes or taxes on interest or dividends. In a Roth IRA, distributions are not taxed at all, instead the money invested is after tax income.
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Start Early
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Contributions to Roth IRAs are limited. It was only in the last decade as of 2010 that Congress has allowed higher earners to contribute more to a Roth IRA. $5,000 or the amount equal to adjustable gross income, whichever is less, can be contributed on an annual basis. Individuals over 50 can contribute $6,000 under the current limitations established by law.
There are cutoffs for contributing to a Roth IRA: $167,000 for a married couple two earner family, $120,000 for a single head of house hold and a non working spouse earning less than $10,000 is ineligible to contribute.
If one expects to be a high income earner during peak earning years, the sooner one gets a Roth IRA, the better.
Emergencies
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One advantage of a Roth IRA is that contributions can be removed at anytime from the Roth IRA with no tax penalty. Money earned in the account cannot be withdrawn without the IRS 10 percent penalty. If an emergency occurs, one should always have savings in place and avoid reaching in to retirement savings. Emergencies happen, however, and being able to withdraw contributions with no penalty is a real advantage. Just like other tax deferred savings accounts, one can still borrow against it and pay it back. The advantage of a Roth IRA is even greater flexibility.
Potential of a Roth IRA
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Roth IRAs can be more lucrative then traditional deferred tax savings plans. According to Kiplinger's, a 25 year old investing $5,000 can expect an 8 percent return on her investment. At retirement the account could have $1.4 million in it. Doing the same thing with a traditional IRA or 401k, where you have to pay income taxes, would result in earnings of only $1 million. Significant tax exposure can be avoided with a Roth IRA.
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References
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