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What is a Roth IRA?

Roth Individual Retirement Arrangements (IRAs) are special accounts designed to help individuals save for retirement. A Roth IRA is funded with after-tax dollars and only the earnings are taxed when distributed. A Roth IRA is a great way to compliment a 401k or protect your assets if you think your tax rate will be higher in the future.

About Roth IRAs

Named after Senator William Roth, Jr., Roth IRAs were first made available in 1998. Roth IRAs are a special type of account designed to help an individual save fore retirement. Roth IRA accounts differ from other retirement accounts in that they are funded by post-tax dollars. Like a Traditional IRA, there are annual contribution and distribution limits. Unlike a 401k, 403b, or other employer-sponsored retirement account, IRAs are opened and funded by the individual investor. Because you are responsible for the account, you can choose any asset type to place in your account. Because of this, many investors use a Roth IRA to house tax-inefficient investments such as frequent stock trades or assets like small cap mutual funds.

Why a Roth IRA?

Roth IRA & the importance of retirement saving: In the past, pensions and Social Security have largely assisted individuals with a means to retire. Today, the burden of saving for retirement lies more and more on the individual, leading more people to seek out IRAs and other tax-advantaged accounts to save for retirement. With most Americans saving very little of their paycheck, the fate of Social Security questionable, and large companies cutting benefits, it has never been more important to have an individual retirement account that you control. For many people, a Roth IRA account is an integral part of their overall portfolio in saving for retirement.

The true power of retirement accounts, whether they are employer-sponsored or individual, is in the ability of the funds to grow without annual taxation. The most important factor in compound interest is that of time, so the earlier you begin saving, the more time your account has to grow. There are dozens of examples out there to show how saving 5 or 10 years earlier shows differences at retirement in the tens of thousands of dollars. Roth Accounts allow you to take control of your retirement planning by allowing you to pick the assets you want, when to contribute, and withdraw your contributions at any time without penalty.

Roth IRA as an emergency fund: Because contributions to a Roth IRA can be withdrawn at any time, many people use a Roth IRA as an emergency fund. As long as there is not an emergency, you have retirement savings growing tax-free. If you do encounter an emergency, contributions in a Roth IRA can be withdrawn and used to pay off the expenses. As long as the earnings are not withdrawn, there is no tax penalty. While some think an emergency fund in a Roth IRA is a great idea, others advise against it for a variety of reasons. For one, mixing retirement accounts and emergency funds seems to go against the original idea behind the Roth IRA. Others note that the Roth IRA is ideal for tax-inefficient assets and you will probably want low-tax, safe, liquid assets in an emergency fund.

Roth IRA vs. 401k and Other Plans

A Roth IRA will ideally not be your sole retirement account. Hopefully your company provides a 401k, 403b, or other retirement account. Since company sponsored plans typically provide a match on employee contributions, there is no reason to miss out on that kind of return. Every star wall-street manager cannot come even close to the 50%, 100%, or even 150% match some companies provide each year on a portion of your pay. However, if you reach the amount your company matches and still want to save more, a Roth IRA provides an excellent place to continue saving. Since contributions to a Roth IRA are made post-tax, the dollar in your Roth IRA is worth more than the pre-taxed dollar in your 401k. And since you control exactly what goes into your Roth IRA, you can chose different funds, choose an annuity, or even hold Certificates of Deposit to compliment your other retirement account. After you meet your company’s match and then reach your annual contribution limit for the Roth IRA, you next best option is to continue to fun your 401k, even without the match. The tax benefits of these accounts far outweigh holding money in a taxable account for your retirement.

Roth IRAs are a type of retirement accounts
Click to expand. Roth IRAs are a type of individual retirement accounts with unique eligibility, contribution, and distribution rules.

Other Retirement Accounts

There are many other ways to save for retirement while still receiving some sort of tax protection. While most companies provide 401k programs, there are also Roth 401k programs that allow post-tax savings sponsored by the employer, 403b plans for government-approved organizations, and traditional IRAs. Government savings bonds and tax-managed index funds are excellent ways to protect yourself from taxes in non-retirement accounts. Depending on your individual needs and income, any of these plans can help you save for retirement.

References

  • "Creator of Roth IRA dies." Associated Press. msnbc.com, 14 Dec. 2003. Web. 10 Feb. 2012. < http://www.msnbc.msn.com/id/3711630/ns/politics/t/creator-roth-ira-dies/ >.
  • Photo Credit: John Duricka / Associated Press < http://www.msnbc.msn.com/id/3711630/ns/politics/t/creator-roth-ira-dies/ >


Next: Learn About Roth IRA Contribution Limits

Page last modified 2/26/2012