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How Does a Roth IRA Work

By Edited Dec 22, 2015 0 0

One of the unique features of the United States tax system is the Roth IRA which allows your money to grow unencumbered for decades. If you are not using a Roth IRA, and you are eligible, you are probably going to want to open one after you realize the many advantages that the Roth IRA will afford your savings rate. So, let's take a look at how an IRA works.

How does a Roth IRA work?

A Roth IRA is a special kind of arrangement (account) that allows your money to grow (as your investments increase in value) without the usual tax consequences. The Roth IRA was named for the former senator William Roth of Delaware. It was created to allow individuals to accumulate a greater nest egg so that they would have more money when they retired.

The reasons for this arrangement are multiple. First the government believes that by letting you keep more of your money (and paying them less taxes) you will actually need fewer government services in your retirement years. This is a major concession from the Congress because by permitting the Roth IRA's existence they are actually stripping themselves of millions in tax money. Which, I am sure, was tough for them considering how much Congress likes to spend the people's money.

Who is eligible for a Roth IRA?

There are currently a few restrictions that the government keeps on the Roth IRA. The main two restrictions that you need to be aware of are the IRA contribution limits and the Roth IRA income limits. Let's look at each. First are the contribution limits. Currently, a person can only contribute $5,000 a year to their Roth IRA, so in that way it is unlike a 401k, though that amount will go up in the future according to a scale that is tied to inflation. The other restriction is the Roth IRA income limits. Because IRAs are such a great deal the government limits who can participate in them. Rich people are not eligible to participate with a Roth IRA account so they will have to pay taxes on all of their investment earnings. So, remember that next time someone tells you that rich people are always getting the breaks!

Now, the thing about Roth IRA's that make them so great for ordinary investors is that when it is time to retire you can withdraw your money tax free! Yes, that's correct you will not have to pay any taxes on it. Actually, let's back up a second. When you first invest your money in a Roth IRA (and this is the big difference between a Roth IRA and a traditional IRA) this money will have already have been taxed. So, you do not entirely escape paying taxes, but you pretty much do. Let me explain.

Let's say that you make $5,000 a month and take home $4,000 after taxes. You can then open an IRA account and fund it, assuming you meet the IRA eligibility requirements, with money that you have already paid taxes on. So, let's say that you put everything that you made last month into your Roth IRA. Let's also assume that you leave your money in an investment where it gets 7% a year until you decide to retire in 25 years -- which is an entirely achievable return. By that time your $5,000 (remember you paid $1,000 in taxes) will be worth $20,989 and when you take it out you do not have to pay a penny more in taxes! All that money is yours!

If you are eligible, and most people are, you can open a Roth IRA at just about any bank, investment company or online broker for free. There are numerous excellent online companies that offer this service. I have heard nothing but good things about T. Rowe Price and Scottrade (where no fee IRAs are the rule) though I personally use Sharebuilder for my Roth IRA and I recommend them fully.

Well, for those of you who were wondering, "How does a Roth IRA work?" Now you have your answer. And if you think that you are going to need more money to retire than you currently have in savings, a Roth IRA might be the right choice for you.



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