What is a Roth IRA?

A Roth IRA (Individual Retirement Account) is a Tax free retirement account permitted under the U.S. Federal tax law.   

Benefits of a Roth IRA:

• Any money you put into a Roth IRA savings account grows absolutely tax free.
• Unlike your paycheck, a Roth IRA is not taxed as your savings accumulate,
• A Roth IRA is not taxed when you cash it out in retirement.
• An IRA is more flexible than a 401(k) and other retirement plans because you can invest it almost any way you want, in securities, usually common stocks or mutual funds,  although other investments, including certificates of deposit, and real estate are permitted.

Here is an example to illustrate the benefit in the future of the tax savings associated with a Roth IRA:

• If a 25-year-old contributes $5,000 each year until he retires at age 65, and makes an average annual return of 8% on his investment, he´ll have $1.4 million saved by retirement.
• If the same individual put aside the same money in a regular taxable investment account, and received the same annual return of 8%, he would pay at least 15% Federal tax  (in the LOWEST tax bracket), and it would accumulate to only $1 million.

Setting Up Your Roth IRA

Not sure where to find the money to fund your account?

• Consider investing your tax refund. About 70% of the US will get a refund this year, and last year the average check totaled more than $2,000. Use it to start your Roth IRA.
• Or make small contributions from your paycheck through direct deposit, which will most likely not even be noticeable in your overall budgeting.

Rules

• The government’s limit on how much you can contribute to a Roth IRA in 2008 is $5,000.

Starting in 2009, contribution limits will increase in $500 increments based on inflation. With all IRAs, there are specific eligibility and filing status requirements mandated by the Internal Revenue Service. The main advantage of a Roth IRA is its tax structure. More Benefits of a Roth IRA

• You can access your Roth IRA to buy your first home.  The IRS lets you cash out up to $10,000 from your Roth IRA tax- and penalty-free -- which can include earnings -- to help you purchase your FIRST home. If the Roth IRA has been opened for five years, you can use tax-free money from the Roth IRA to purchase your first home. The $10,000 limit is per person, and couples can withdraw up to $20,000.
• You can access your Roth IRA funds if you have a financial emergency.  You can withdraw your contributions at any time, tax free and without penalty.  There is no requirement to pay back withdrawn funds, as there typically is with a 401(k) savings plan. All of the contributions you make to a Roth IRA and the earnings from a Roth IRA may be withdrawn tax free after you have reached age 59½, provided the five year maturity of the Roth IRA has been achieved. With a traditional IRA, earnings (dividends and interest) are taxed as ordinary income and withdrawals prior to age 59½ are likely to result in a penalty.
• You can make contributions to a Roth IRA even if you also participate in an employer’s 401(k) savings plan, with some restrictions. Since they have already been taxed, direct contributions to a Roth IRA may be withdrawn at any time without taxes or penalties,

Disadvantages of a Roth IRA

• Contributions to a Roth IRA are not tax deductible: Contributions to a Roth IRA do not reduce your adjusted gross income (AGI) for tax purposes.
• Eligibility to contribute to a Roth IRA is limited or prohibited above certain income levels.

A traditional IRA may make more sense than a Roth IRA for a taxpayer in a moderate or higher tax bracket.  Individuals in higher tax brackets who contribute to a Roth IRA will pay taxes on the contribution at their current tax rate; but with a traditional IRA, they would defer the taxes on the contribution until they withdraw at a retirement, when they are likely to be in a lower tax bracket.