Retirement Basics: Roth IRA

Roth Individual Retirement Account (IRA) is a retirement account that has been named after Senator Roth, who played an instrumental role in bringing this retirement account into existence. The Roth IRA is the second most popular investment vehicle used in the United States of America, the first one being 401(k). The popularity of the Roth IRA account is because of the several features that this account provides. In this article, we will have a look at some of the important features of this account.

What is a Roth IRA Account?

A Roth IRA is a retirement account. This means that the money held in this account is usually held for long periods of time, i.e., till the retirement of the individual. Contributions to retirement accounts are generally tax-free all across the world. In the United States also, the contributions to retirement accounts such as 401(k) are tax-free. However, in the case of a Roth IRA, the account has to be funded with after tax dollars. This means that the amount invested in a Roth IRA cannot be used to generate a deduction on your income and thereby claim a tax refund.

However, that does not mean that investing in a Roth IRA does not generate any tax breaks. The tax breaks are not generated immediately. The input into the account is taxed. However, the output from the account is tax-free. It is assumed that the money is being withdrawn after the age of 59 years and 6 months. Any withdrawal prior to reaching that age will have to pay the penalty to the tune of 10%. This penalty can change from time to time.

This is in contrast with the 401(k), where the input is tax-free, and the output is taxed. However, this is also what makes the Roth IRA a very powerful tool, particularly if the money is invested for long periods of time. For instance, if you paid taxes on $100 that you put in today and this $100 then grows into $10000 over the course of 30 years, the entire $10000 is now tax-free! Many investors prefer to invest in this tool because it provides them a hedge against the possibly high rates of taxation that may prevail in the future.

Difference between a 401 (k) and Roth IRA?

There are certain differences between a 401(k) as well as a Roth IRA. Some of these differences have been explained below:

  • Wider Investment Options: When it comes to investing in Roth IRA’s, there are a lot more options available for making investments. This is different as compared to a 401(k), where there are fewer options available. An investor can choose pretty much any mutual fund to invest their money in. However, this also means that investors have to be more careful. Since the funds are not vetted or approved by the government, they could also be riskier.

  • Non-Working Spouses: A 401(k) account can only be opened by a person who is working. This means that the account is tied to an employer. However, this is not the case with a Roth IRA. A Roth IRA can be opened in the name of a stay at home spouse as well. The contributions to this account can be made by the working partner. However, the tax breaks and the benefits can be reaped by the non-working partner after they reach a certain age.

  • Contribution Limits: The problem with a Roth IRA is that it has a lower contribution limit. As of now, investors can contribute only $6000 per person in a year. If they are above the age of 50, this contribution can be increased to $7000. The 401(k)’s have a much higher contribution limit, which keeps on changing from year to year. Right now, the contribution limit is around $19000 for people below 50 and $25000 for people above 50. However, an important distinction here is the fact that 100% of the contribution made to Roth IRAs have to be made by the investor themselves. In the case of 401(k) contributions, several employers match the contribution made by the employee. In some cases, they match 100% of the amount, whereas in other cases, they match only 50% of the amount.

  • Income Limits: There is a limit to the people who can contribute to the Roth IRA’s. The government wants to make sure that this tool is not misused by the rich as a tax-efficient vehicle to invest in the stock markets. This is the reason that they have placed limits on the annual income of people who can invest in this account. The limits keep changing from year to year. However, right now, the limit is $122000 for an individual and $193000 for a married couple. It is also important to note that only income earned from salaries or wages can be used to fund these accounts. Other incomes gained from capital gains, rents, etc., cannot be used to fund this account.

The bottom line is that the Roth IRA is a different product that has been created for meeting the investment needs of a different kind of investor. It has several advantages, and the ability to compound money in a tax-free manner is probably the biggest one.

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