Definition: A Roth IRA is a tax-free retirement plan that allows retirees to withdraw their money at retirement without paying any taxes on the account’s earnings. In other words, a Roth allows contributors to put money into the account post tax letting the account grow tax free. In fact, a Roth IRA is similar to the traditional IRA, but its distributions are tax-free upon withdrawal.
What Does Roth IRA Mean?
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Eligibility for a Roth IRA requires an account in good standing for 5 years and the account holder to be at least 59.5 years old. Contributions to a Roth IRA are made after-tax and the account holder can withdraw the funds upon retirement without paying any taxes. Since Roth IRA contributions are not tax deductible and taxes are paid upfront, a key factor to consider before starting a roth is your income level’s tax rate. There are also limitations based on your tax-filing status.
Roth IRAs allow contributions at any age and holders are not forced to mandatory withdrawal amounts when they reach a certain age, unlike the traditional IRA where account holders must withdraw their money at the age of 70.5. Also, a Roth IRA allows contributions even if the account holder participates in another retirement plan.
Let’s look at an example.
Example
Beth is interested in investing $5,000 in a Roth IRA and she is checking out the tax rate. For Beth’s level of income, the tax is 25%. Thus, she has to pay $1,250 for taxes upfront. This leaves her with $3,750 to invest in the retirement plan. Let’s assume Beth leaves her money in the account long enough to double in value. Thus, she will be able to withdrawal $7,500 from her account tax free.
Also, if she has contributed $3,750 to her Roth IRA for 25 years, it sums up to a total contribution of $93,750. Assuming that her account earns $12,000 in interest, it sums up to a total balance of $105,750. Again, this money can be withdrawn without paying any taxes.
As you can see, the question between investing in a Roth or Traditional IRA is a question of current and future tax rates. A roth is best contributed to when your current tax rate will be lower than your future one.
