You may have heard about the Roth IRA, but you may not be entirely clear on what it is; the Roth IRA is an Individual Retirement Account providing tax free growth. It is quite possibly one of the simplest and possibly one of the most effective, of the sheltered accounts available.
Rather than getting taxed twice, or more, like you would with a regular tax investment type account with a Roth IRA you will be taxed one time only. This is basically how the Roth IRA works in comparison with others:
Accounts Taxed Regularly
- After you pay income tax you make a contribution of post-tax dollars.
- The principal is possibly subject to taxes on both capital gains and dividends while it grows.
- When you withdraw you will pay capital gains tax.
- You receive a tax deduction that will essentially allow you to deposit what is considered pre-tax dollars.
- The principal is tax free growth.
- Income tax is paid on the whole amount that you withdraw.
- You will pay income tax then make the contribution using post tax dollars.
- The principal is considered tax free growth.
- There are no further taxes when you withdraw.
The advantage of using a Roth IRA rather than the regularly taxed type of account is evident; you will pay income tax in the beginning but by using a Roth IRA you are through with paying taxes, while with the other regular account it is just beginning.
The Roth IRA advantage over the deductible IRA is almost as evident:
- The Roth IRA is simple – there is no type of special reporting that has to be done to the IRS, while the deductible IRA must have a reported deduction on the 1040 form anytime you have a contribution and on a withdrawal you have to report the whole withdrawal as taxable income.
- If you think that tax may rise in the future then Roth IRA is an advantage since you pay now instead of later.
- A Roth IRA is flexible since you take care of the taxing obligations in the beginning you will likely face far fewer restrictions at a later time.
Keep in mind that the Roth IRA is meant to be used as a retirement account; meaning that you may impose penalties if you withdraw too early. A good rule of thumb is to not make any kind of a withdrawal for five years after the first contribution or until you reach the age of 59 1/2, whichever one is later.