Roth individual retirement accounts offer after-tax savings, so you don't get a tax deduction for contributing. You generally can invest the money however you want, with a few restrictions on collectibles such as gems or self-serving investments such as a vacation home. A bank could offer you a fixed interest rate on your contributions for 10 years, like a certificate of deposit. With a fixed rate, you know how much your Roth IRA will be worth.
No Annual Taxes
One of the tax benefits of using a Roth IRA is that the money grows tax-free in the account, so you don't lose a portion of your interest each year to income taxes. For example, say you earn $500 in interest in a regular savings account. That counts as taxable income, so if you fall in the 31 percent tax bracket, you have to give up $155, essentially reducing your gains to $345. That reduces the amount of interest you earn in future years. With a Roth you don't owe any taxes, so the entire amount continues to grow.
Future Value Formula
To figure the future value, add 1 to the interest rate as a decimal. Then, raise that to the power of the number of years you continue to add payments. Next, subtract 1 from the result. After, divide the result by the interest rate expressed as a decimal. Finally, multiply the result by the annual contribution. In this example, add 1 to 0.0434 to get 1.0434. Then, raise 1.0434 to the 10th power to get 1.529355058. Next, subtract 1 to get 0.529355058. After, divide 0.529355058 by 0.0434 to get 12.19712116. Finally, multiply 12.19712116 by the annual contribution of $5,000 to find it will be worth $60,985.61.
Taxes on Distributions
If you're taking a "qualified distribution" from a Roth IRA, you don't owe any taxes on the withdrawals -- of principal or earnings. In this case you will have opened the Roth IRA 10 years earlier, so you meet the criteria that the Roth IRA be open for at least five years. But you also must be at least 59 1/2, permanently disabled, or taking out no more than $10,000 for a first home. If you're not, you still can take out your contributions tax-free before you dip into any earnings that built up on the principal. If you do make a non-qualified withdrawal of earnings, you pay taxes and a 10 percent early-withdrawal penalty on them.
Not everyone is eligible to contribute to a Roth IRA. And just because you're eligible to contribute in one year doesn't mean you'll be eligible every year in the future. To contribute, you must have compensation -- earned income or taxable alimony paid to you -- and your modified adjusted gross income can't exceed the limits for your filing status. If you're not eligible but you contribute anyway, the IRS imposes a 6 percent excess contributions penalty, which continues to apply every year that you don't correct it.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."