Roth individual retirement accounts, introduced in 1998, offer after-tax savings for retirement. These benefits are particularly useful for people who expect to pay a higher tax rate in retirement. The contribution limits for Roth IRAs are cumulative with traditional IRAs, so before you switch where your contributions go, weigh the pros and cons.
If you're contributing to a retirement plan for the tax deduction, a Roth IRA doesn't offer any such benefit. Roth IRAs are after-tax accounts, which means you can't take a tax deduction for contributing, but your money will still grow without being taxed while it remains in your Roth IRA. For example, if you buy and sell stock in your Roth IRA, you won't have to pay taxes on each transaction.
Roth IRAs share the compensation requirement with traditional IRAs, meaning that you must have income that you earned from working in order to contribute. Your modified adjusted gross income, which includes both earned and unearned income, must fall below the IRS limits for your filing status. If you — and your spouse if married — make too much money, you can't contribute to a Roth IRA.
Qualified withdrawals from a Roth IRA come out tax-free, but there are standards that must be met for qualified withdrawals. You have to be at least 59 1/2, or permanently disabled, and your account must be at least five tax years old. Tax years count from January 1 of the first tax year you made your contribution. For example, if you made your first contribution during the 2013 tax year, you can't take qualified distributions until 2018.
Since you didn't receive a tax break on your contributions, you get to take out the money you contribute, but not the earnings, tax-free at any time. In addition, when you take distributions, you don't prorate your distributions. Instead, you remove all your contributions first, and only then do you begin to take out earnings. The 10-percent early withdrawal penalty only applies to the taxable portion of an early distribution — the earnings — so as long as you don't take out more than you've put in, you won't owe a penalty.
Roth IRAs don't require you to take required minimum distributions as long as you live, unlike other qualified retirement plans that start making you take out the money when you turn 70 1/2. As a result, you can keep enjoying the tax-sheltered growth of the Roth IRA until you actually need the money.
- TAX TIME image by brelsbil from Fotolia.com