A Roth IRA is a type of individual retirement arrangement (IRA) that allows tax-free withdrawals on income and growth.
Most people are familiar with employer-based 401(k) retirement plans and their individual plan cousin, the IRA.
A second type of IRA, known as a Roth IRA, works the same way as a normal IRA with one major difference: Money you put in today is not free of income tax, yet withdrawals later on are free of both income and investment taxes.
For instance, if you put $5,000 into a 401(k) or a traditional IRA this year, you would in most circumstances be able to reduce your taxable income by that amount. That reduces your total income tax bill at both the federal and state level for the year.
You will be taxed on that money later on, when you withdraw the money in retirement, but only at your income tax rate in the year you take out money.
A Roth IRA, in comparison, offers you no reduction in taxable income this year. The money you contribute is taxed now.
However, once contributed it can grow and compound for decades. When you take Roth IRA money out to spend, there is no tax on that income, no tax on the reinvested dividends and no tax on the growth of your investments.
A Roth IRA is best thought of as a tax tool. There’s nothing special or different about the underlying investments in a Roth IRA. Since it’s an IRA, you can put your money into stocks, bonds, mutual funds, index funds — any investment available to IRA investors.
The power of compounding and prudent investment management in a typical retirement can turn relatively modest contributions over years into a significant source of retirement income. However, once you reach the point of needing to take money out of your retirement accounts, that money will be taxed as income.
Your 401(k) plan income will be taxed, as will any traditional IRA income. In many states, Social Security is taxed too, and you will pay federal tax on Social Security payments, of course.
For many retirees, all this can seem like a non-issue. After all, you can take Social Security first, then rely on retirement plan withdrawals to tide you over for the difference.
Ah, but then the RMDs kick in. Required minimum distributions (RMDs) are the government’s way of ensuring that it collects tax at some point during your lifetime. You got the advantage of tax-free growth for years; now Uncle Sam wants his piece, too.
RMDs start at age 70-and-a-half and affect both 401(k)s and IRAs. In the case of 401(k), they can start at your retirement date, which might be earlier. Then, according to IRS actuarial tables, the minimum amount you must take out (and pay income tax on) goes up steadily.
A Roth IRA allows you to better control your total tax bill. For instance, you might choose to delay Social Security income (and the taxes on that) until your maximum retirement age, a number which adjusts depending what year you were born but is between 65 and 67 under current law. You also get more if you wait, too.
You might choose to put off taking money out of an IRA or 401(k), too, or keep working and contributing. Another route would be to take a portion of your tax-free Roth IRA money each year in order to avoid a higher tax bracket.
Finally, some folks use Roth IRA money as a kind of estate planning tool, taking out taxable income to live on and leaving tax-free Roth IRA accounts behind for children and grandchildren. Because of the withdrawal rules around inherited IRAs, they can take out less over their longer lifetimes and let compounding turn small dollars into large balances by their retirements.