You've probably heard of a Roth IRA, but unless you understand the basic features and advantages of these plans, you haven't fully explored your retirement savings options.
If you play your cards right, a Roth IRA can save you money on taxes over the long haul, and yet they are a little more flexible than most retirement plans, such as traditional IRAs and 401(k) plans. As such, starting a Roth IRA can be an ideal way for a young person to start saving for retirement.
Roth IRA rules
A Roth IRA is a form of Individual Retirement Arrangement, which means that it is an account that qualifies for special tax treatment as long as certain conditions are met. The following are some key rules of Roth IRAs:
- Contributions are not tax deductible, but qualified distributions from the account are not taxable.
- Interest and investment gains within the Roth IRA are not taxable.
- As of 2010, contributions were limited to $5,000 per year, or $6,000 if you are aged 50 or older. Expect these limits to increase over time.
- Contribution limits for each individual apply to all IRA contributions by that individual, so any amount you contribute to a Roth IRA reduces the amount you can contribute to a traditional IRA, and vice versa.
- Allowable contribution amounts start to be reduced, and are eventually eliminated, at higher income levels. Be sure to check the applicable limits for your filing status and the current tax year before making a contribution to a Roth IRA.
- Distributions from a Roth IRA are free from federal income tax if you are above age 59 1/2 and the Roth IRA has been in place for at least five years.
- You may also qualify for tax-free distributions from a Roth IRA if you are disabled, or if you are using the money to buy your first home.
- Money in a Roth IRA can be invested in a variety of ways, from conservative savings accounts to more aggressive investments like stocks and bonds.
Analysis: How is a Roth different from a traditional IRA?
Roth IRAs differ from traditional IRAs in three distinct ways:
- With a traditional IRA you save money on the front end by taking a tax deduction on your contribution. With a Roth IRA you save money on the back end because qualified distributions are not taxable.
- Roth IRAs are more flexible than traditional IRAs about making exceptions to distribution restrictions for things like buying a first home or coping with disability.
- Traditional IRAs typically require you to start taking distributions after you reach age 70 1/2.
Why consider a Roth IRA?
Based on the above differences, you might consider a Roth IRA if you believe you are in a lower tax bracket now than you'll be in when you retire, or if you think tax rates in general will rise significantly in the future.
You might also consider a Roth if you like the idea of being able to withdraw money without penalty to buy a first house, or if you become disabled.
Those distinctions make opening a Roth IRA especially appealing for younger savers, who may be in a relatively low tax bracket, and might need some flexibility as their careers and programs get under way.
How do you size up this issue? Did you opt for a traditional or a Roth IRA, and why did you make that choice?