Risks of a Roth IRA
A Roth Individual Retirement Account (IRA) reverses the contribution and distribution paradigm originated by its sibling, the traditional IRA. In a traditional IRA, your contributions are made on a pre-tax basis, meaning that your money is only taxed when you withdraw it. With a Roth IRA, you pay tax on your contribution first, then withdraw your funds tax-free in retirement. Risks to the Roth IRA lie in the uncertainty of future events, and in some of the regulations imposed by the Internal Revenue Service (IRS).
Other People Are Reading
-
Investment Risk
-
Although a Roth IRA possesses many tax advantages to help the long-term growth of your account, the account itself is still merely a holder of your investments, not a guarantor. In other words, the same risk to owning stocks, bonds and mutual funds in a regular taxable investment account exists inside a Roth IRA as well. In order to mitigate your investment risk, you should apply the same asset allocation and account diversification principles that you would in any other investment account.
Five Year Window
-
One of the main benefits of a Roth IRA account is the ability to take qualified distributions from the account without paying any income tax. However, an important regulation stipulates that you must wait 5 years after you fund a Roth IRA before you can take any tax-free withdrawals. If you take a distribution during that 5-year period, then any earnings on your distribution must be included in your gross income for the year, and subject to taxation. The contribution, or "basis" portion of your withdrawal will not be taxed as it was taxed before it was deposited.
-
Early Withdrawal Penalties
-
As with all IRAs, if you withdraw any funds from your Roth IRA before you turn 59 1/2, you may be subject to a 10 percent penalty tax on the amount of the withdrawal. While exceptions to this rule include unreimbursed medical expenses, first time home purchases, or disability, this rule applies to Roth IRAs even if you are taking a withdrawal after the 5-year window has passed.
Conversions and Tax Brackets
-
If you convert a traditional IRA to a Roth IRA, you pay income tax on the full amount of the conversion in exchange for your tax-free Roth withdrawals in retirement. Before you convert, you should assess the risk of paying tax now versus paying tax later. If you are in a high tax bracket now, your conversion is taxed at this high tax rate. If you are in a lower tax bracket in retirement, which you may be if you stop working and your income falls, you may have been better off taking taxable withdrawals from a traditional IRA in retirement, rather than paying the higher tax earlier on.
-
References
Resources
- Photo Credit TAX TIME image by brelsbil from Fotolia.com
