When Congress first authorized individual retirement arrangements in 1974, the idea was to provide a means of allowing workers who didn't have access to a qualified retirement plan at work to set aside some of their earnings toward their own retirement. One of the key advantages of these traditional IRAs was the ability to deduct your contributions from your income when you filed your tax return. Congress later introduced the Roth IRA, which has its own set of benefits, but tax-deductibility is not among them.
Most people who have earned income can make non-deductible contributions to a Roth IRA, but there are limitations based on your income. You can't contribute to a Roth IRA if you file your taxes using the married filing jointly or qualifying widow(er) filing status and your modified adjusted gross income exceeded $179,000. The maximum adjusted gross income for people who file as single or head of household, and those who are married filing separately but did not live with a spouse at any time during the year is $122,000. Married people who file separate returns and who live with their spouse at any time during the year lose the ability to contribute to a Roth IRA if they earned more than $10,000.
You can use the funds in your Roth IRA to purchase virtually any kind of investment you wish, other than life insurance policies or collectibles. Any growth in your Roth IRA occurs tax-deferred. You don't have to report the earnings on your annual income tax return, and you don't have to pay any income taxes on the earnings, but in the event your account declines in value, you cannot deduct any current losses that occur in your Roth IRA account, either.
You can only fund your Roth IRA with after-tax dollars, which means you can't deduct your contributions from your taxes. Since you've already paid income taxes on the money you used to fund your Roth IRA, you can withdraw those funds at any time, for any reason, without creating a taxable event. You can withdraw the earnings produced by investments in your Roth IRA tax-free after you've held a Roth account for at least five years, provided you are at least 59 1/2 years old, disabled or use the funds to buy or build a first home.
All of the money in your Roth IRA belongs to you, and you have the option of withdrawing any or all of it at any time. If you withdraw the earnings portion of your Roth IRA before those funds have become qualified, the IRS will tax those funds as ordinary income. You will also get hit with a 10 percent tax penalty.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.