While the Traditional IRA was a welcome addition to the retirement savings arena, many people were unsatisfied with some of its limitations and requirements. Their complaints registered with the US Congress and in 1997 this body passed tax legislation that permitted the creation of the Roth IRA. This did not replace the Traditional IRA but rather exists as an alternative alongside it.
What Is a Roth IRA?
A Roth IRA shares many similarities with a Traditional IRA. It is best to describe it in terms of distinctions between this investment savings arrangement and the older version created in the 1970s. The Roth IRA is chiefly distinct from a Traditional IRA due to the taxation to which it is subject.
You do not achieve any tax savings on the funds that you contribute to a Roth IRA. Contributions are taxed as normal income for that year.
However, this taxation means that the funds suffer fewer restrictions with regard to access than Traditional IRAs. When you withdraw funds from such an account upon retiring, you do not have to pay any taxes on it because taxes were already assessed at the original time of contribution.
Advantages of a Roth IRA
- You can withdraw funds from a Roth IRA tax-free. You do not have to wait for retirement. The fund is always accessible, just like any other savings account.
- You are never required to withdraw from a Roth IRA. You can let the funds accumulate and pass on to your heirs.
- You may rollover funds from a traditional IRA into a Roth IRA.
- Participants in a Roth IRA may also hold 401(k) retirement plans simultaneously.
- When the owner of a Roth IRA dies, the beneficiary of that owner may combine the funds with his or her own Roth IRA. There is no penalty for this action.
- You can pass the Roth IRA on to your heirs without penalty.
- These investment schemes are ideal for people who believe that they will be in a higher tax bracket upon retiring since the disbursed funds will not be taxable.
- Donations to the fund are essentially larger, even if they are for the same amount, since they have already been taxed.
Disadvantages of a Roth IRA
- Unlike most employer-sponsored retirement programs, a Roth IRA has income limits.
- Contributions do not reduce your adjusted gross income.
- The benefits of a Roth IRA are not as immediate as those of a Traditional IRA because there are no initial tax savings. Consequently, if you do not live to retirement, you will probably never experience any benefit from this retirement plan.
- There is a growing expectation that the US Congress will change the rules of Roth IRAs and begin to tax them in response to the present financial troubles of the government.
A Roth IRA is an excellent alternative to Traditional IRAs. As long as you are able to make an accurate estimate of your expected taxation at the time of retirement, you can determine which IRA is better for you.
Jeff Rose from Good Financial Cents