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Roth IRA

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Get to Know your Roth IRA

Investing into a retirement fund might seem a bit preemptive at this stage of your life, especially if you’re still in school. And you might be right. However, the earlier you start money management with retirement in mind, the more money you gain interest on, and the more you will have to live off of. Thinking about having money 40 years down the road is pretty abstract, but understanding how a Roth IRA works will open opportunities – and your mind – to why Roth IRAs are so important.

A Roth IRA is a type of individual retirement account (IRA) that differs from the traditional IRA in many ways – the biggest advantage of which being the tax structure. A Roth IRA account only gets taxed once instead of twice or more like in a deductible or traditional IRA. Some other differences, as provided by IRS.gov, are:

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  • If you satisfy the requirements, qualified distributions are tax-free
  • You can make contributions to your Roth IRA after you reach age 70
  • You can leave amounts in your Roth IRA as long as you live
  • The account or annuity must be designated as a Roth IRA when it is set up

Once an individual sets up a Roth IRA account, contributions can be made throughout the tax year. Money can be drawn out of the account 5 years after you create the account, providing you are 59 at that time. Clearly that won’t be the case if you are considering opening a Roth IRA now, but it is something to keep in mind when putting money away in your savings account.

Sometimes the best way to look at something as complicated as a Roth IRA, or any retirement savings plan for that matter, is to take a step back and look at the basic investment rules surrounding the plan.

The 2010 Basic Rules for a Roth IRA Account

  • You cannot qualify for the maximum contributions and benefits of a Roth IRA if your AGI is more than $105,000. If you are married, your AGI has to be less than $167,000
  • Your earned income must be at least as much as the amount you want to contribute to the Roth IRA, meaning you cannot contribute more than you make
  • A Roth IRA account holder can only contribute up to $5,000 between January 2nd and April 15th of the following year (for example, January 2nd 2010 to April 15th 2011)
  • Individuals 50 and over can make additional “catch up” contributions of $1,000 (meaning their yearly contributions can equal up to $6,000)
  • Contribution limits tend to change with the current years inflation
  • You must make money to open any IRA account, not just a Roth IRA (there are certain exceptions for spouses)
  • There are no age restrictions on Roth IRAs

Why Choose a Roth IRA instead of a Deductible IRA?

Many adults who have already established a traditional IRA have been switching all or parts of their IRA to a Roth IRA due to the amazing tax benefits. It is pretty obvious why a Roth IRA is better than a regular IRA; the following table shows some of the differences:

Roth IRA vs. Deductible IRA
Roth IRA
Deductible IRA
  • You pay income tax, then make your own contribution with post-tax dollars
  • Your principal grows tax-free
  • You pay no further taxes on withdrawl
  • You get a tax deduction, essentially letting you deposit pre-tax dollars
  • Your principal grows tax-free
  • You pay income tax on the entire amount of your withdrawl

As you can see, a Roth IRA and traditional IRA don’t really compare. Whereas both have upfront taxes, with a Roth IRA you’re done with taxes after the initial startup, as opposed to constantly getting hit by taxes with a regular IRA.

The comparison between a Roth IRA and Deductible IRA are almost as obvious, but some of the reasons are not shown on this chart. As the chart does show, with a Deductible IRA you have to pay taxes on your final withdrawal. In addition, a Roth IRA requires no special reporting to the IRS. With a deductible IRA you have to report a deduction on your 1040 form when you make a contribution and on withdrawal you report the entire withdrawal amount as taxable income.

When the time does come for you to set up your retirement funds, use this as a guide for deciding between a regular and Roth IRA. The advantages of a Roth IRA cannot be ignored.

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