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How Roth IRAs Work

Pros and Cons of Roth IRA Contributions
A Roth IRA can help increase the size of your nest egg.
A Roth IRA can help increase the size of your nest egg.
Copyright © iStockphoto/ YinYang

A Roth IRA offers many lucrative benefits, such as flexibility on withdrawals and distributions, an array of investment opportunities and the minimal tax penalties associated with it. There are, however, a few drawbacks to a Roth IRA.

First of all, if you do have an employer-sponsored retirement program, such as a 401(k) or a 403(b), and your employer matches your contributions, you should always use this investment opportunity first. Never pass up an opportunity to receive free money from your employer! Investing in a Roth IRA should be used as a secondary investment plan for retirement, after you've reached the maximum contribution amount with your employer-sponsored retirement program.

Secondly, the maximum annual contribution you can make to a Roth IRA may be substantial for some people, but not much at all for other people. It's all relative to your lifestyle. While most 401(k) programs have an annual maximum contribution amount of 12 percent of your adjusted gross income (your taxable income), the set Roth IRA contribution amount of $5,000 or $6,000 annually can be significantly less than that. For example, a single 33-year-old guy earning $70,000 a year can only contribute just over 7 percent of his annual salary to a Roth IRA. Fortunately, a Roth IRA can be set up in addition to other retirement accounts.

Another drawback of the Roth IRA is that contributions to it aren't tax- deductible. For many people considering opening a Roth IRA, this is a very important factor. However, the benefit of no tax on Roth IRA earnings upon withdrawal at maturity date tends to outweigh the benefits of having a tax deduction.

Here are two more important things you should know about a Roth IRA. First, keep in mind the current Roth IRA contribution limits. If you go over the maximum contribution limit for the year, you must withdraw the excess funds prior to filing your income taxes for that year. If you don't withdraw these funds in time, you will be subject to a 6 percent tax on the excess funds. Next, be aware of Roth IRA income limits. If your annual income gradually increases over the years and you find yourself at the maximum income level, you're no longer eligible to contribute to your Roth IRA. You can leave the money in your Roth IRA as is and watch it grow over time while you invest your big, fat salary into other retirement plans. To find the best Roth IRA and other retirement plans for you, consult a financial planner.

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