How Does a Roth Work?

Saving for retirement is one of the most important financial activities you can partake in during your working life. The more money you put away for invest for retirement, the more it will grow, which can enable you to enjoy a higher standard of living in your later years. A Roth individual retirement account (IRA) is a type of retirement plan that offers unique tax benefits that can help you save for retirement.

Roth IRA Basics

There are two basic types of IRAs that individuals can open themselves regardless of the retirement plans offered by employers: traditional IRAs and Roth IRAs. A traditional IRA lets you make contributions that are tax deductible, similar to a 401(k) plan. Roth IRAs, on the other hand, must be funded with after-tax income. The benefit of a Roth IRA is that you can withdraw your money and any investment gains during retirement tax-free. With traditional IRAs and 401(k) plans, you must pay income taxes on your withdrawals.

Contributions

The IRS states that contributions to IRAs are limited to $5,000 a year, or $6,000 if you are 50 or older. This limit applies to both traditional IRAs and Roth IRAs. You must also earn less than a certain amount of income to be eligible to contribute to a Roth IRA. The IRS states that your income must be less than $177,000 as a married person filing a joint return to contribute to Roth IRA. Single taxpayers must have income less than $120,000 to be eligible for Roth IRA contributions.

Withdrawing Funds

Once you reach age 59 1/2, you may begin withdrawing funds from a Roth IRA without penalty, so long as you have had the account open for at least five years. If you attempt to withdraw investment gains before age 59 1/2, your withdrawal may be subject to a 10 percent early withdrawal penalty. You may, however, withdraw your contributions at any time without penalty. This contrasts with 401(k) plans and traditional IRAs where you must pay the 10 percent penalty on contributions you withdraw before age 59 1/2.

Considerations

Traditional IRAs and 401(k) plans force investors to make minimum required withdrawals starting at age 70 1/2. Roth IRAs are not subject to required withdrawals and you may continue contributing money to the account at any age.

References

• IRS: Publication 590 (2010), Individual Retirement Arrangements (IRAs)
• CNN: How is a Roth IRA Different from a Regular IRA?
• CNN: What are the Advantages of the Roth Version?
• CNN: When Can I Take Money Out of a Roth?