A Roth IRA allows you to pay taxes upfront and pay no taxes when withdrawing for retirement. The money you originally put into a Roth IRA has no immediate tax advantage. However, as the value grows over the years it grows tax-free. When you withdraw the money and the increase in retirement, you owe no taxes on either.
Roth IRAs are particularly advantageous to people investing early in their careers who are in a lower tax bracket. A lower tax bracket means that the advantage of a traditional IRA -- lowering taxes now -- is less of an incentive. Also early in one's career investments have the maximum potential for growth. The growth of the original investment may be many times the original value by the time one retires. This means the tax paid upfront may be insignificant compared to the tax saving in the future.
On the other hand, Roth IRAs require a certain level of trust in the government. New rules could possibly negate some of the advantages of Roth IRAs. For example, switching to a federal sales tax rather than income tax would make the future value of a Roth IRA much less.
Benefits of a Roth IRA
- Ideally you want to be able to take a lot more money out of an IRA than what you put into it. Roth's let you keep this larger amount tax free.
- The original amount put into a Roth IRA has already been taxed, so it can be removed at anytime without penalty.
- Assuming that income tax will go up, a Roth IRA allows you to pay now and not pay at a higher rate later.
- Roth IRAs are generally very simple to setup and don't require much paperwork and can be setup by an individual on their own.
Disadvantages of a Roth IRA
- The laws could change in a way that would require tax to be paid.
- Roth IRAs give no tax advantage now, so you may have less to invest once the IRS has taken their share.
- If you will be in a lower tax bracket when you retire, the Roth IRA may result in a higher tax burden.
- Roth IRAs have much lower contribution limits than other types of retirement accounts.
History of the Roth IRA
Roth IRAs were created as part of the Taxpayer Relieve Act of 1997. The Roth IRA gets its name from William Roth, a senator from Delaware who pushed to have them included in the bill.
Fair Tax Implications
The fair tax movement is trying to get the US to switch to a consumption based tax. This would mean income would no longer be taxed, but spending would be. If this were to pass, Roth IRAs would effectively be taxed because tax would be paid when they were used to purchase goods. This means that the benefits of the Roth IRA would never be realized. The money would be treated the same as money in a normal savings account. You paid tax on it when you earned it and then you paid tax on it when you spent it. If Fair Tax goes into effect, money in a traditional IRA will have an advantage because it was put in tax free. With Fair Tax you would be able to spend it paying tax, but without having to pay tax on it when it was originally earned.
Roth IRA FAQ
- Do I have to pay tax if I take money out of a Roth IRA before retirement?
- You can always take out the money you put in because you already paid taxes on it. So if you put $5,000 into a Roth IRA and it grows to $10,000, you can withdraw the original $5,000 without any tax consequence.
- Is a Roth IRA better than a regular IRA?
- That depends on your financial goals. Generally, if you are making less now than in retirement and are young a Roth IRA will probably offer you the best return on your investment. If you are reaching retirement age and want to minimize your taxes today a traditional IRA may give you a better tax treatment. Of course laws can change so it may be good to have a mixture and some money in a Roth IRA and other money in a traditional IRA.
- Can I roll my 401k to a Roth IRA
- Yes. You will have to pay taxes on the money you roll over because taxes were not payed originally.
- When do you pay taxes on a Roth IRA?
- Taxes are paid up front on a Roth IRA. You pay taxes now, so you don't have to pay taxes on on the original or the gain when you take it out in retirement.
- Can you borrow money from a Roth IRA?
- Since you already paid taxes on the original amount, it can be removed any time without incurring taxes or penalties. So you can "borrow" the original money you put in and then put it back in later.