If you are in the process of saving for retirement, you’ve probably heard of Roth IRAs by now, or at the very least traditional IRAs. So what is a Roth IRA? In this article, we’ll give you a basic understanding of traditional and Roth IRAs, including what they are, how much you can contribute, when you can take withdrawals, the differences between the two and much more.
What is an IRA?
Since traditional IRAs came first, we’ll talk about those before we discuss what is a Roth IRA. In general, an IRA is an individual retirement account. It’s a way for individuals to save for retirement in addition to or in place of a retirement plan at work (401K, 403B, profit sharing plan, etc.). An IRA is invested in different investment securities, such as stocks, bonds, mutual funds and even real estate (self directed IRAs).
There are several types of IRAs, including traditional IRAs, Roth IRAs, Individual Retirement Annuities, Simple IRAs, and SEP IRAs. This article will focus mainly on Roth IRAs, but we’ll discuss traditional IRAs briefly as well.
Traditional IRAs were introduced in 1974 by the Employee Retirement Income Security Act (ERISA). They were created to allow individuals who didn’t have access to company retirement plans to save for retirement in a tax-deferred account. Individuals were allowed to contribute up to $1,500 per year in the original IRAs, and their taxable income was reduced for the amount of contributions they made, in the form of a tax deduction.
In 1981, IRAs were expanded by the Economic Recovery Tax Act (ERTA) to allow anyone under age 70 ½ to contribute to an IRA as long as they had earned income, regardless of whether they had access to a company sponsored retirement plan or not. The annual contribution limit was also increased to $2,000 at that time. Another important change was the ability to contribute $250 to an IRA for spouses who didn’t work.
Many other changes have taken place to the traditional IRA including increasing the contribution limit for both workers and non-working spouses (the contribution limit is $5,000 in 2010), phasing out the tax deduction for contributions made by high earning workers who have an employer sponsored plan, and allowing catch-up contributions for older workers.
What is a Roth IRA?
Perhaps the most significant change was the creation of the Roth IRA in 1997 as part of the Taxpayer Relief Act. So what is a Roth IRA? Named after its main legislative sponsor, Senator William Roth of Delaware, the main difference between a Roth IRA from other tax advantaged retirement plans is that the tax break is at the withdrawal level instead of the contribution level. With traditional IRAs you get the tax break up front in the form of a tax deduction; with Roth IRAs you get the tax break at the back end, as qualified withdrawals are tax-free.
Roth IRAs are a great tool for people saving not only for retirement but for college, buying your first house, and other goals. Here are some of the advantages that Roth IRAs have over other retirement accounts:
- Earnings from contributions or converted funds grow tax-free, and may be taken out tax and penalty free once the taxpayer reaches age 59 ½, or if other qualifying events take place.
- Contributions to a Roth IRA can be withdrawn tax free at any time, for any reason.
- Funds that were converted from a traditional IRA can be withdrawn tax free after five years.
- Up to $10,000 (lifetime maximum) in earnings can be withdrawn tax free if the funds are used to purchase a principal residence for a first time home buyer.
- Contributions to a Roth IRA can be made even if the person participates in a qualified retirement plan through work (such as a 401K).
- Roth IRA owners do not have to take distributions at age 70 ½ like owners of traditional IRAs do (the required minimum distribution or RMD).
- Roth IRAs can be passed to beneficiaries at the owner’s death; the contributions and earnings remain tax fee, making this a very valuable estate planning tool.
Which is Better – a Traditional or a Roth IRA?
Roth IRAs may not be best for everyone. Just like any investment account, there are disadvantages that may make Roth IRAs less desirable for some investors:
- Contributions to Roth IRAs are not deductible, so you don’t get a tax break for contributing to a Roth IRA. This will make Roth IRAs less desirable for taxpayers who are in a high tax bracket now.
- People who earn over a certain income may not be able to contribute to a Roth IRA, whereas there are no income limits for 401Ks and other employer sponsored retirement plans.
- For people who are close to certain adjusted gross income (AGI) phase-out limits, contributing to a Roth IRA vs. a traditional IRA may cause them to miss out on valuable deductions or credits such as the Child Tax Credit or the student loan interest deduction.
- You may pay more taxes on the earnings used to make Roth IRA contributions then you will pay on the funds that would have later been withdrawn from a traditional IRA.
- The perceived tax benefit from contributing to a Roth IRA instead of a traditional IRA may never be realized. This could happen if you are in a much lower tax bracket when you retire (and thus withdraw from the Roth IRA), or if tax laws change before you reach retirement age.
As you can see, the rules regarding Roth IRAs can be very complicated. The IRS has very specific requirements for all IRAs, including who’s eligible to contribute, when contributions are deductible, when taxpayers can take money out of the IRA, how withdrawals are taxed, and more. While the Roth IRA may be best for one person, a traditional IRA may be better for another; therefore, it’s important you do some careful tax planning before you invest in a Roth IRA or any type of investment. It’s possible that a variety of tax advantaged accounts may be best for you (you want to diversify for tax purposes just like you do for investment purposes). The best thing to do is to contact a tax professional or financial planner who specializes in tax planning to help you develop a strategy that will maximize your financial goals while minimizing your tax burden.
I hope this article was helpful in answering your question “what is a Roth IRA”.