What Is A Roth IRA?
The Roth IRA, named after the late Senator William Roth of Delaware (the Roth IRA's chief sponsor), is a particular type of Individual Retirement Account (IRA).
In case you aren't familiar with IRAs, they're government sponsored retirement savings accounts which provide advantageous tax benefits to help you save more money for retirement.
A traditional IRA is tax deductible, meaning the account is funded with pre-tax earnings from your paycheck, which lowers your overall taxable income for the year.
Since lowering your pre-tax income could push you into a lower income tax bracket, that might translate into a lower tax bill...
That's just one advantage.
In addition, the money you sock away then grows free of capital gains and income taxes until you withdraw it in retirement. With a traditional IRA, once you reach the threshold age of 59.5, you can begin withdrawals, which are then subject to income tax.
But that's a traditional IRA. A Roth IRA is even better...
Avoid Paying Taxes
So what is a Roth IRA?
While a Roth IRA is NOT tax deductible (meaning you fund it with after-tax dollars), its additional benefits more than make up for this negative.
Because once you fund your Roth IRA with after-tax take home pay, you're finished paying taxes.
Did you catch that?
You're done paying taxes.
With a Roth IRA, your investment portfolio grows free of capital gains and income taxes for as long as you wish.
However, unlike a traditional IRA, once you decide to withdraw your money, it's not subject to income taxes. After all, you already paid the income tax prior to making the original investment.
At first glance, this may not sound like much of a difference, but it's enormous...
Keep More Of Your Money
Let's imagine for a moment that you've invested $5,000 in a traditional IRA (the annual maximum) and $5,000 in a Roth IRA (the annual maximum). Each grows at a rate of 10% annually for 30 years, and your tax rate is 25%.
Here's what would happen...
Initial Traditional IRA Contribution: $5,000 (maximum allowed)
Annual Compounded Rate of Return for Both: 10%
Traditional IRA Balance After 30 Years: $87,247.01
Obviously, not much difference.
Before making that call, remember that you have to pay taxes on withdrawals from a traditional IRA, while Roth IRA withdrawals are tax-free.
Accounting for taxes, here's the final result...
Traditional IRA Balance After 30 Years: $65,435.25 (after-tax)
The Roth IRA just saved you $21,811.76...!
Now, in all fairness, the traditional IRA contribution was tax deductible, while the Roth IRA contribution was not...
This means if you had contributed $5,000 pre-tax to the traditional IRA, and only $3,750 after-tax to the Roth IRA (so your take-home pay remained the same), your end result would also have been the same.
But if you plan on making the maximum contribution each year, then the Roth IRA has a decided advantage over similar retirement accounts in that it offers tax-free withdrawals.
But the Roth IRA has other unique traits as well...
Unlike traditional retirement accounts, no minimum or maximum age requirements exist for opening or funding a Roth IRA. The only requirement is for the accountholder fund the account with earned income.
Keep Control Of Your Money
In addition, a traditional IRA currently requires you to begin withdrawing funds at age 70.
But what if you don't want to withdraw funds?
What if you don't need the funds until age 75 and want to keep growing them tax free until that time? With a Roth IRA, you can keep your account growing tax free for as long as you want. No law requires you to begin taking withdrawals.
If you invest your Roth IRA in the stock market, this can be a tremendous advantage.
Well, imagine you prudently invest your traditional IRA in the stock market for decades. You build a nice little nest egg, perhaps even an inheritance for the children and grandchildren.
You decide that that at age 70, you'll sell all your stocks and put the proceeds in less volatile certificates of deposit (CDs).
Unfortunately, at age 69, the stock market tanks.
It loses 50% of its value in a single year! Sound familiar?
With a traditional IRA, you're required to sell while the market is low... and then pay taxes on top of that! But with a Roth IRA, you can wait for a market rebound or, if you wish, even contribute more to your account while stocks are cheap.
It's this flexibility and freedom of choice which make the Roth IRA such a desirable option for retirement planning.
Should You Have A Roth IRA?
All this sounds great, right?
Does that mean you should have a Roth IRA?
It's difficult to say. Each person's financial situation is different.
But because of the obvious benefits of investing tax-free money for the rest of your life, it's very difficult to envision a financial scenario in which a Roth IRA isn't a great fit. As a general rule, if you're eligible and can afford to set one up, then you should have a Roth IRA.
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