Investors have been flocking to individual retirement accounts (IRAs) for decades; first offered in 1974 as part of the Employee Retirement Income Security Act (ERISA), IRAs are now a primary retirement planning tool for millions of Americans. For most investors, traditional IRAs offer the ability to make tax-deductible contributions and enjoy tax-free growth. It’s only when one starts to withdraw funds that taxes due, as regular income on the amount of the withdrawal only.
The Taxpayer Relief Act of 1997 introduced another variety of IRA — the Roth IRA. What is a Roth IRA? Named for Senator William Roth of Delaware, who sponsored the legislation, Roth IRAs, like their earlier cousins, offer tax-free growth of retirement savings. However, contributions to Roth IRAs are not tax-deductible. The benefit lies in the withdrawals, which, in nearly all cases, are entirely tax free. The advantage therefore lies in the back end, not the front end.
As with regular IRAs, annual contributions to Roth accounts are limited to the amount of one’s total earned income for that year, or $5,000, whichever number is less. Investors aged fifty or more can make an additional “catch-up” contribution of $1,000, for a total of $6,000 (again, assuming the investor has earned at least that much in compensation during that year). These limits are adjusted on an annual basis; the figures provided here are for the 2012 tax year.
While anyone with earned income can invest in traditional IRAs, there are restrictions on who can open and contribute to Roth accounts. Taxpayers who file singly must earn less than $110,000 in a given year (as defined by the taxpayer’s modified adjusted earned income, or MAGI) to be able to make the full Roth contribution for that year ($5,000, or $6,000 for those aged fifty or more). If a single filer’s MAGI is between $110,000 and $125,000, that person make a partial contribution, on a sliding scale. Those with a MAGI of $125,000 and more cannot contribute to a Roth IRA. (As above, all figures are for 2012.)
Married taxpayers filing jointly have higher limitations: they can each make full contributions with a MAGI of less than $173,000, partial contributions with a MAGI between $173,000 and $183,000, and no contribution with a MAGI over $183,000. If their income qualifies them, both spouses can contribute to their own Roth IRAs even if one spouse has no earned income, provided the working spouse has earned at least as much as the couple’s total contributions for the year.
Investors can withdraw from their Roth accounts at any time, but may face a 10 percent early withdrawal penalty if the withdrawal is made before the investor has reached 59½ years of age, or if the investor has held the account for less than five years. The penalty for early withdrawal is assessed only on the earnings of your account — not on the original contributions. And in various cases, you can withdraw money from your account at any time completely penalty free, depending on how you use the money. Qualifying reasons include college expenses, medical expenses, a first-time home purchase, and paying costs associated with a sudden disability.
And there are no required withdrawals from a Roth account once you’re in retirement, as there are for regular IRAs. Because your withdrawals are 100 percent tax free, the Internal Revenue Service doesn’t care whether you make withdrawals or not. A Roth account, therefore, is perfect for savers who may wish to keep their IRA intact, for instance to pass on to an heir.
For most people, a Roth IRA is more advantageous than a regular IRA, but you should do the math and work through various scenarios before deciding on what’s best for you.
IRA Calculator will help you determine:
IRA calculator helps you decide whether a Traditional or Roth IRA is best suited for your needs.
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How you can forecast for your contributions’ affect on your retirement savings can be done through our online 401-K calculator.