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How Roth IRAs Work


What's a Roth IRA?

In the 1970s, the United States government realized that many Americans did not have pension plans available through their employers, and Social Security simply would not provide enough income for the average American to retire and enjoy a comfortable lifestyle. The traditional IRA was created in 1975 to help compensate Americans who did not have employee-sponsored retirement plans. In the 1990s the U.S. government expanded on the traditional IRA to offer more flexibility to IRA contributors. The Roth IRA was born as a result of the Taxpayer Relief Act of 1997.

Named for the late Senator William V. Roth Jr., the Roth IRA was developed not only to help middle-class America save for retirement, but also to offer a savings plan that could be used to purchase a primary residence, pay for medical expenses, or fund a child's college education. The Roth IRA can be set up at any bank or brokerage firm, and its terms are extremely flexible. Roth IRAs allow for early withdrawal of your original contribution (not the earnings) without penalties after a 5-year waiting period. The earnings generated from the original Roth IRA contribution can also be withdrawn early, but the profit is subject to penalties.

The money invested in a Roth IRA has already been taxed, so any return you earn on your Roth IRA investments won't be taxed, as long as you wait until you're at least age 59 ½ to withdraw your profits. On the other hand, contributions to a traditional IRA are taxed as income upon withdrawal. Just remember, a traditional IRA is tax deductible, but a Roth IRA isn't.

The beauty of the IRA, in general, is that you're free to invest the money in your IRA however you chose. Some common Roth IRA investment options are common stocks, index funds, bonds, certificates of deposit (CDs) and REITs (real estate investment trusts). The flexibility that comes with being able to invest your Roth IRA as you choose, as well as being able to withdraw funds early or leave them long after your 71st birthday, make the Roth IRA immensely popular. Keep reading to discover what role age plays in Roth IRA contributions.