What is a Roth IRA and how can you benefit from it?

Article Category: Finance  |   

First, the good news: the Roth IRA is a retirement plan for US citizens that isn't usually taxed. Now the bad news: this applies only in certain conditions (for example, you'll only avoid paying tax if your investment has satisfied a five year holding period). Sorry to burst the bubble, but it had to be done. Now for the good stuff...

You've probably arrived at this page looking for some pearl of wisdom to help sway your decision on where to invest your retirement funds, right? Well, in that case, keep reading.

What is a Roth IRA?

Roth, IRA, 401k eggs - photo

As we've already noted, it's an investment vehicle you can use to fund your well-earned and, quite possibly, fun packed twilight years.

This type of IRA can be funded from your post-tax salary. What's more appealing to many investors is the fact that withdrawals are exempt from federal tax. Now, there are rules governing this last statement and we'll cover those shortly.

Benefits of a Roth IRA

Because contributions to a Roth IRA are made after you've paid income tax, the withdrawals you make from the fund are tax free (in most circumstances). This key aspect is why this type of investment is favored by many newcomers to the labor market.

On the other hand, the mechanism by which the 401(k) works means you'll actually end up paying more as you're taxed on the amount available on withdrawal. The 401(k) does allow you to take a loan from your fund, but you have to repay the amount within a specified time limit or face being taxed on the money you've taken out.

Other advantages of the Roth IRA include:

No upper age limit for contributions - you keep on investing for as long as you want. And, There is no mandatory point requiring you to begin withdrawals. By contrast, the 401(k) is quite restrictive as you're forced to start taking out your cash from the age of 70 and 6 months. This is not ideal if you're looking to keep topping up your funds beyond this age.

Most importantly, your contributions to the Roth IRA can be perpetual regardless of your employment situation. What this means is that you can still add to the fund when you leave your employer. Because the 401(k) is part of your employment terms, it will cease when you shift jobs and you'll have to go through the process of setting up a new fund.

How Much Can You Invest?

Currently, as of mid-2014, the limits for a Roth IRA are $5,500 if single and $6,500 if married (assuming an AGI of $112,000 and $127,000 respectively).

Now, those sums seem fairly paltry when compared to the maximum amount of $17,500 that you can invest in a 401(k), but don't forget the big tax benefit you'll have handed down to you. In addition, there's the added advantage of having no upper age limits on the funds you can add to a Roth IRA. What this means is, should you wish to, you can turn your investment into a very nice little nest egg that can be passed on to your heirs.

Investment Example

Ok, so now you have an idea of how the Roth IRA works I'm guessing you'd also like to see how much you can save, right?

First off, let's assume you're married. Second, let's assume a reasonable retirement income of $22,000 a year. Third, let's say you'll start paying in at the age of 22 and stop at 65.

Based on those figures, investing $384 a month at an average inflation rate of 3.25% will see your fund swell to just under $1.8 million.

Whether you spend it or pass it on, it's a very tidy sum of cash.

Key Takeaways

Only you can decide which type of investment fund is appropriate for you retirement - always seek advice from qualified financial advisers before jumping. But, with that last point in mind, here's a quick recap on the benefits of a Roth IRA:

  1. Withdrawals are tax free
  2. No upper age limit for investing in this type of fund
  3. No enforced withdrawals based on your age (or any other factor)
  4. Requirement of 5 year existence of plan before tax free withdrawals
  5. Can be passed on as a form of inheritance (but will be taxable as part of your gross estate)
  6. Is not tied to a specific employer's terms of employment

Written by James Redden
With thanks to Glenn Cunningham

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Last update: 29 July 2014

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