Those of us steeped in the personal finance blogosphere find it incredible to think that there are those who have no knowledge of the Roth IRA. However, it is true that at one time I had no idea what the Roth IRA was — and I was probably about the same age as the college seniors who surprised Jeff Rose not too long ago, providing the inspiration for a Roth IRA movement.
Luckily, my research into finances and my time as a freelance writer allowed me to learn about the Roth IRA, which will give a huge boost to my retirement.
Tax-Free Growth with the Roth IRA
One of the reasons that the Roth IRA is such a great retirement savings tool is that your money grows tax-free. When you contribute money to your Roth IRA, it goes into investments of your choosing, and you aren’t taxed on your earnings. When you withdraw money from your Roth IRA later on, during retirement, you don’t have to pay taxes on the withdrawals. This is what appeals to many.
Of course, this tax-free growth later comes with a price now. Contributions to the Roth IRA are made with after-tax dollars. This means that you don’t get a tax deduction for the money you put in. You pay your taxes now, rather than later.
The Traditional IRA is tax-deferred, meaning that you pay taxes later. You get a tax deduction now, for your contributions, saving you money immediately. However, later, when you withdraw the money from your retirement account, you have to pay taxes on the amount you withdraw — as if it’s regular income. If tax rates go up in the future, or if you retire in a higher tax bracket, you end up paying more.
One of the reasons that many like the Roth IRA is due to the fact that there is a good chance that you can pay lower taxes now, and avoid higher taxes later. Since the money in the Roth IRA grows tax free, you pay taxes at your current tax rate. That means, of course, that if taxes increase between now and your retirement, or if you retire in a higher tax bracket, that you won’t have to worry about paying taxes at that higher rate — you’ll already have paid them at a lower rate.
Downside to the Roth IRA
The biggest downside to the Roth IRA is that the contribution limits are so low: You can only contribute up to $5,000 this year. There is a catch-up contribution of $1,000 allowed for those 50 and older, but the fact remains that you can contribute far less to a Roth IRA than you can to a 401(k). (If you have a spouse who doesn’t work, you can use a spousal Roth IRA to help improve your household’s overall ability to contribute to your retirement.)
And, with the Roth IRA, there are also income limits. Your ability to contribute to a Roth IRA begins to phase out when your AGI reaches $173,000, and disappears altogether at $183,000.
Even with these drawbacks though, a Roth IRA can still be a great retirement tool — especially if you start early and contribute as much as you possible can.
Do you have a Roth IRA? Do you contribute the maximum?
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