Roth IRAs and how one can help you meet your retirement goals
Paying taxes ranks among people’s least favorite activities. While that may be the case, many Americans are unaware that losing substantial portions of their hard-earned money to taxes is not as inevitable as they may believe. Fortunately, the IRS has allowed a number of ways for ordinary middle-class Americans to lessen their tax burdens.
One of the best ways for individuals to reduce their long-term tax bill is through the use of a Roth IRA. A good Roth IRA definition is that it is an individual retirement account that allows taxpayers to invest their money after paying taxes in a wide variety of investment types and the investments will grow tax free.
The thing that differentiates a Roth IRA vs. a traditional IRA is that any earnings that occur within the account are not taxed upon withdrawal, including capital gains, dividends and interest. Funds can compound within a Roth IRA and may eventually be completely exempt from all taxes.
Roth IRA definition and explanation
The main difference of a Roth IRA when compared to a traditional IRA is how taxes are treated. A Roth IRA is is an account that allows post-tax contributions whereas a traditional IRA offers pretax contributions. This can be of great benefit to those who are currently in a high marginal tax bracket but who expect to need less upon retirement.
Another aspect of the Roth IRA is that this type of retirement account allows people to withdraw funds at any time without incurring immediate income taxes. Many other forms of retirement accounts penalize most withdrawals with a 10 percent early-withdrawal fee, and are subject to immediate taxation at the prevailing rate for the individual. The Roth IRA allows for tax-free withdrawals at any time up to the total amount you contributed, with a 10 percent early withdrawal penalty only being applied for certain non-qualified withdrawals. Furthermore, there are special exemptions for first-time home buyers and college expenses. This can make Roth IRAs an excellent choice for those who may need to access their funds before reaching the age of 59.
Roth IRA vs traditional IRA
The Roth IRA differs in many important ways from that of a traditional IRA. A Roth IRA compared to a traditional IRA has a number of very different limits that are imposed on the accountholder. While both accounts allow a maximum yearly contribution limit of $6,000, Roth IRAs have strict limits imposed on the maximum yearly income that an accountholder may earn before their ability to contribute to their Roth IRA is phased out. There are no yearly income limitations on the ability to contribute to a traditional IRA.
Another aspect of the Roth IRAs is the fact that the same age limits do not apply with a Roth IRA vs a traditional IRA. Those with traditional IRAs are subject to so-called required minimum distributions or RMDs. These are forced minimum withdrawals that one must make starting at the age of 70 1/2 years. On the other hand, Roth IRAs have no such required withdrawals.
Another benefit is that Roth IRAs allow retirees who do not need the funds in their retirement account to pass that money, in full, onto their heirs or significant others. Another consequence of the Roth IRA is that spouses who inherit the one benefit from certain major tax advantages, including the ability to combine the inherited Roth IRA with their own and continue to enjoy tax-deferred growth, with no penalties.
Different tax treatment
A significant difference that is inherent in the Roth IRA is the very ways in which Roth IRAs compared to traditional IRAs are taxed. With a few very specific exceptions, any withdrawal that takes place from a traditional IRA before the accountholder turns 59 ½ years old will be subject to the 10 percent penalty and full ordinary-income taxation as noted above. However, the Roth IRA allows accountholders to make qualified, tax- and penalty-free withdrawals from their accounts.
One difference of a Roth IRA compared to traditional IRA tax treatment is that anyone who has waited at least five years from the time they opened their Roth IRA account can make penalty-free withdrawals if they meet certain criteria. Those include becoming disabled, being past the age of 59 ½, a spouse inheriting the funds within the Roth IRA or the funds being used towards the purchase of a primary residence. However, Roth IRAs stipulate that this latter use may only be for amounts up to $10,000 and can only occur once in the accountholder’s lifetime.
Ultimately, the primary benefit of early withdrawals from a Roth IRA compared to a traditional IRA is that the latter are immediately subjected to normal income tax upon withdrawal. Conversely, the Roth IRA guarantees that any funds in will not be taxed as they have already been subjected to regular income tax prior to being deposited in the Roth IRA account.
Roth IRA versus 401(k) and other retirement account types
As noted, the chief difference between the Roth IRA and the way that non-Roth account types are defined is the way in which the taxes are deferred. Traditional IRAs have tax-deferred contributions and Roth IRAs have tax-deferred growth. Another major difference between the Roth IRA and other retirement accounts is whether or not they are employer-based. Since the Roth IRA is an individual retirement account with tax-deferred growth, people may want to explore the possibility of employer-based or self-employed retirement account types. The most popular of these is a 401(k), which also has a Roth variant that closely matches the Roth IRA definition.
Roth IRAs versus 401(k)s
To those unfamiliar with retirement accounts, it may be hard to distinguish the meaning of Roth IRAs from that of 401(k)s and other defined-contribution employer retirement plans. The chief difference between 401(k)s and the Roth IRAs is that the former is run by an employer or some form of company where the accountholder is the owner.
Because 401(k)s are meant to replace the older defined-benefit plans, which were once among the sole means of income whereby most Americans relied on their retirement, 401(k) plans offer far higher annual contribution limits. And all contributions to these accounts are 100 percent tax deductible below $18,500 per year.
Another key difference when considering Roth IRAs is that the sole source of contributions will be the accountholder. Contrast this to employer-run defined-contribution plans, like a 401(k), where employees may be able to take advantage of large matching contributions from their employer. Because matching contributions can add up to tens or even hundreds of thousands of dollars over decades, this difference between 401(k) and Roth IRA is extremely important to consider.
For those who have the option of choosing whether to contribute their money to a Roth IRA or an employer-matched defined-contribution plan, other things that define a Roth IRA may come into play. The things that typically define a Roth IRA include a wide range of potential investments from which to choose from. Many ways to diversify one’s portfolio define a Roth IRA. Contrarily, 401(k)s are typically very limited in the selection of investments that are offered to accountholders.
Roth IRAs longer term
A Roth IRA from an investment standpoint, is that of an individual means of saving for retirement that can significantly benefit from high growth. Roth IRAs will generally yield the best performance for those who can tolerate a higher risk profile and look for high growth.
The Roth IRA ensures that returns that compound within the account can be distributed without being subject to income taxes. This means that capital gains, dividends and interest will not be taxed at all when they are withdrawn, assuming the withdrawal criteria have been met.
This Roth IRA guarantees that those who amass a large retirement nest egg will benefit from the elimination of all taxes related to withdrawals, including the case where accumulated assets are passed on to heirs. This Roth IRA definition means that this individual retirement account type can be a great option for younger investors as well, who are most likely to benefit from tax-free compound growth over decades.
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