Roth IRAs are possibly one of the best gifts Congress has ever given the retirement saver. The advantages over Traditional IRAs are significant (we will get into those in a subsequent post), but in this post let's focus on the basics of what a Roth IRA actually is and how it works.
A Roth IRA is an individual retirement account (see where the acronym comes from?) that allows after-tax deposited dollars to grow tax free for the rest of your life.
What? English please.
Okay. A Roth IRA is typically a brokerage account, just like any other brokerage account where you can buy stocks / bonds / mutual funds / etc. The difference is the tax nature of it.
Your contributions (the amount you deposit into the account) are AFTER-TAX contributions. This means you already paid income tax on this money (likely withheld from your paycheck by your employer, if not you will owe it when the tax man comes calling in April) and you will not get a tax deduction for your contribution. This is the same as a taxable brokerage account, but is different from a Traditional IRA where you get a tax deduction for the contributions you make that year.
Quick example. You make $100,000 in wages from your employer which is reported on your W-2. Your employer withholds and remits to the IRS a certain amount of taxes from your paycheck, which may or may not be the correct amount based on your personal situation (married, kids, home ownership, other deductions, etc.). If we assume you are married filing jointly, have no other income and no other deductions you will owe $11,444 in taxes on that $100,000 (hopefully your employer withheld most of that).
Traditional IRA Contribution: Now, if you contribute $5,500 (the max allowed this year) to a Traditional IRA, your taxable income will be reduced to $94,500 and you will owe $10,166. If your employer withheld the whole $11,444 then you will get back about $1,300 when you file your tax return. You will subsequently owe tax on the principal and the gains when you take the money out in retirement.
Taxable Account Contribution: If you instead contribute the $5,500 into a taxable brokerage account, your taxable income will stay at $100,000 and you will owe the full $11,444 of tax, meaning you likely won't get that $1,300 back on your tax return. Additionally, each year you will need to pay capital gains tax on any realized short-term or long-term gains.
Roth IRA Contribution: Alternatively, if you contribute the $5,500 to a Roth IRA, your taxable income will still stay at $100,000 and you will still owe the full $11,444 meaning you likely won't get that $1,300 back on your tax return. BUT, your $5,500 will grow tax-free for the rest of your life. You will never need to pay tax on the principal or the gains ever again.
The comparison of a Roth IRA to a taxable account should be obvious. Do you want to go the rest of your life and not pay tax on your gains or do you want to pay tax every year you realize gains? If you can't answer that one then... well... either I feel bad for your parents or the IRS is your favorite charity to donate to. But all kidding aside, the one reason it actually isn't as easy as that is because contributions to a Roth IRA (and a Traditional) are locked up (unless you want to pay a 10% penalty) until you are 59.5 years old. This liquidity issue actually should come into play in the decision making process.
The comparison of whether to contribute to a Roth or Traditional IRA is quite a bit trickier and we will devote a separate blog post to discussing the advantages and disadvantages of both.
The fine print: Growth in a Roth IRA can be taken out tax free as long as you have remained in the Roth IRA for a period of at least 5 years and are above 59.5 years of age. Withdrawals from both Traditional and Roth IRAs taken before the age of 59.5 years of age will result in a 10% penalty from the IRS on the withdrawn amount.
Roth IRA Contribution Limits: In 2015, the IRS does not allow you to contribute more than $5,500 into a Roth IRA per person per year (if you are married your spouse can contribute as well). However, there are income limits where the amount the IRS allows you to contribute begins phasing out. These phase outs begin when your modified adjusted gross income is greater than $116K if single or $183K if married filing jointly.
NOTE: There are actually ways to contribute to a Roth even if you are over this income level. We call it "ghosting into a Roth" and will have a subsequent post on this.
Hopefully that covers the basics of the Roth IRA structure for you. In subsequent posts we will get into more details of how you can take advantage of a Roth, regardless of your income level.