Understanding Roth IRAs
If you are starting to plan for retirement, it’s easy to get confused by the number of instruments that exist to help you with that plan. This is especially true since so many of those instruments have complex rules regarding how they can be used without incurring tax penalties that undermine their purpose. That’s not surprising, but it does mean you need a guide to each instrument. One of the most important steps in seeing how the instruments fit together is understanding the makeup of a Roth IRA and how it differs from traditional IRA investments.
When you invest in a traditional IRA, the contributions tend to be free of federal taxes, but you can count on paying tax on the funds that are disbursed from it during your retirement. Roth IRAs work the other way. Contributions to them are subject to federal income tax, but after you retire, the disbursed funds will not be. This can provide a substantial savings to investors if there is a balance of investment between the two types. There are a few important facts to remember about your IRAs as you decide how to balance that investment, though:
- There is a $5,500 maximum contribution to both kinds of IRA combined
- You may be eligible for up to an additional $1,000 in contributions annually if you fall into the “catch-up” window defined by law
- Roth withdrawals are not subject to the 10 percent federal income tax fee on early withdrawals if the beneficiary is over 59 and a half years of age
- Contributions can still be made up to age 70 and a half if the beneficiary is earning income
- You must be in a Roth IRA for five years before you can take disbursements
- Always keep in mind that the investments are in mutual funds which can lose money
The Roth IRA was built to be advantageous for younger and older investors alike, but the younger you are when you make your contributions, the more benefit there is to making them. That’s because they then have more years to accrue interest and grow your funds, leading to a larger pool of tax-free funds that will be available down the road. By contrast, traditional IRAs are balanced to help you defer immediate tax burdens, so as your income goes up and you reach retirement, the switch to investment in that traditional structure will provide you with a different method of balancing your tax burden.
In the end, the best retirement planning advice will tell you that maximizing your contribution to either type of fund is the most important step. Beyond that, your best strategy will vary according to both your retirement goals and your particular earning situation.