What is a Roth IRA?
A Roth IRA is an individual retirement account that requires the account holder to pay taxes on the money going in, but allows him to withdraw it tax-free. When the account holder anticipates going from a lower tax bracket earlier in life to a higher tax bracket later in life, he might consider a Roth IRA a worthy investment: taking advantage of the lower taxes he pays today can save him money in the future.
Unlike a 401(k) plan, money deposited into a Roth IRA comes from after-tax income. If the account holder thinks her taxes will go up in the future, either from government-mandated tax hikes or because she expects to be earning more income, investing money in a Roth IRA lets her pay her taxes while they’re low. When the account holder withdraws the money after retirement, he gets it entirely tax-free. They also contrast with traditional IRAs, tax-deductible investments that are taxed at regular interest rates after withdrawal.
Roth IRAs consider 59 1/2 to be the retirement age for the purpose of withdrawing money. Before that age, the account holder can make tax-free withdrawals on the amount she’s invested after a five-year “seasoning” period, but if she makes a withdrawal on the interest she may be subject to early-withdrawal fees.
The Internal Revenue Service (IRS) places caps on the amount a taxpayer can contribute each year. As of 2017, the cap is $5,500. However, if the account holder is over age 50, he’s able to contribute an additional $1,000 for a total annual contribution of $6,500.
The account holder’s income must also be below a certain level. For 2017, single filers making less than $118,000 are allowed to make full contributions to a Roth IRA, and those earning up to $133,000 can make partial contributions. For married people filing jointly, the income threshold begins at $186,000, with those making $196,000 able to make partial contributions.
Roth IRAs come with a few caveats that potentially make them less attractive than a 401(k). For one, they can’t be used as collateral for a loan. Second, some people may prefer to have the tax benefits now rather than way down the line, especially if they end up in a much lower tax bracket in retirement. Finally, Congress has the power to change how Roth IRAs work, potentially putting the investment at risk in times of high government debt.
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Roth IRA example
At age 30, Freddy is earning enough income that he decides he wants to invest in retirement. He opens up a Roth IRA, choosing one that has a great interest rate, and puts in 5% of his income from every paycheck. Twenty-nine and a half years later, he’s got his eye on retirement soon. He could wait to take out his investment, but if he takes it out now, he’ll reap the full benefits of his investment while he’s still in a high tax bracket. If he takes it out after retirement, it’s still a decent, tax-free chunk of change, and worth more because of its interest, but the impact it has is smaller because his effective tax bracket is lower than when he started investing.