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A Roth IRA is a special type of individual retirement account (IRA). It was created as part of the Taxpayer Relief Act of 1997 and provides special tax benefits that other retirement plans do not.
Individuals that contribute to a traditional IRA typically receive a tax break on contributions made to that plan. However, any withdrawals made from a traditional IRA trigger taxes.
By contrast, any contributions made to a Roth IRA receive no tax deduction. Therefore all contributions are based on after-tax dollars. However, all qualified withdrawals are tax free.
This special tax benefit makes Roth IRA’s particularly beneficial to younger people. Although your contributions will be with after-tax dollars, you will not be taxed on any capital gains, dividends or interest that you accumulate. Over the course of a 30 or 40 year investment period, this could result in significant tax savings.
Roth IRA’s are also advantageous when tax rates are likely to increase. For example, say the current tax rate is 20 percent. However, with rising deficits it is very likely that the tax rate will rise to 35 percent. In this scenario, you will likely come out ahead by contributing to a Roth IRA plan now with after-tax dollars. Then you will be withdrawing from your Roth IRA during a time of higher taxes (e.g. 35 percent in this scenario).
There are certain restrictions for contributing to a Roth IRA. You can contribute up to $5,000 per year or $10,000 for a couple. Although your contribution is also limited by your total compensation. So if you earned less than $5,000, your contribution limit would be capped at your current compensation level.
Participants in a Roth IRA plan can enjoy tax-free withdrawals as long as they have had their account open for at least 5 years and are age 59 ½ or older.
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Posted on Shalom Adventure by: Barbara Zaremsky
