The term Roth IRA is short for Roth Individual Retirement Arrangement, and takes its name from Senator William Roth who was its main sponsor through legislation. Most people who work for a living want to save for their retirement, and the Roth IRA allows them an alternative to the standard retirement arrangement that was in place until then.
Many people find difficulty in choosing between a traditional IRA and a Roth IRA because they are unsure as to the difference between them, and it is the purpose here to explain some of these differences in order that you can make a proper decision as to the most appropriate way for you to save for your future. You have to make this decision now, since if you leave it too late the contributions you make will not accrue to much of an income on your retirement.
It is important that you understand what a Roth IRA is in relation to the standard arrangement, and that you can make an informed decision based upon accurate information. The Roth is not appropriate for everybody, although most people in the middle income bracket will likely find it to their advantage. It is why this is so that you should understand, and at what level of income there becomes a real choice between the alternatives.
A Roth IRA provides tax-free growth, and is the simplest form of retirement account that you can have. While a normal investment account results in you being taxed twice, a Roth, just like a normal IRA, is taxed only the once. With a normal IRA account, your contributions are tax-deductible (depending on your income) whereas they are not with a Roth IRA. However, you pay taxes on earnings when you withdraw them with the traditional IRA, while earnings are tax-free with a Roth.
This right away introduces in important difference. It might seem an advantage to pay the tax right from the outset, on the contributions that you make rather than on their earnings, because if the tax rate increases then you will benefit from the deal. But what if the tax rate drops? That might result in your losing out, and if that is an important factor in your decision, then you will have to judge the likelihood of each happening, and base the type of IRA you opt for based on that. However, in doing that you would also have to take the other advantages, and disadvantages, into consideration and come to a balanced decision and not base it solely on what your predictions on the tax rates are.
Other differences include no mandatory age for distribution of earnings with a Roth IRA, whereas the normal IRA owners must begin withdrawals at 70.5 years of age. The latter also pay a 10% penalty for withdrawal of funds, including the principal, whereas there is no such penalty with a Roth IRA. There are several other differences between the two, most of them coming from the fact that you have the tax paid up-front with the Roth. The IRS has no further call on your money, as they have with the other forms of retirement account.
As has already been touched upon, this is particularly useful if you believe that taxes might rise later, because your tax has already been paid, although this could be a disadvantage if tax falls. It also allows you to shelter the same amount of money as a traditional IRA, but in tax-paid dollars as opposed to cash on which tax has still to be paid, and assets in a Roth IRA account can be inherited. However, there are also disadvantages, in addition to the falling tax situation and the non-deductible contributions.
One of these is that Roth contributions do not reduce your adjusted gross income (AGI), so that if your income is close to the limit for certain tax credits or deductions, you cannot bring yourself below that threshold by making Roth IRA contributions. Another is that you will never realize the tax benefits until you retire, and claim on the Roth IRA, so that if you do not live to retirement you will lose any tax benefits you might have gained - but by then you probably won't be worrying about that!
There is also the possibility of Congress making rule changes, so that the tax benefits might be reduced or negated altogether. Although this might seem somewhat harsh and unlikely, it is nevertheless a possibility to take into account. Nor is a Roth IRA beneficial to all income levels, and you will have to consider your own situation on an individual basis. In order to commence Roth IRA contributions it will be necessary for you to attain certain income levels from earned income, as opposed to unearned income from investments that are not included in the eligibility calculations.
So, is Roth IRA the best way for you to save for your retirement? Only you will know that, but this website will help you to come to your decision based upon hard facts, and a better knowledge of the regulations and the advantages and disadvantages that you have at the moment.