A Roth Individual Retirement Account (IRA) is a smart way to save for retirement because you can invest post-tax dollars today and avoid paying any additional taxes on earnings in the future -- as long as the account meets certain requirements. The money you contribute to a Roth IRA account may grow into a significant nest egg to help fund your dreams and daily expenses after you retire. Earnings on the account and withdrawals after age 59 1/2 are tax-free.
The Internal Revenue Service (IRS) allows individuals to contribute $5,000 per year if you're younger than 50 years of age, and $6,000 if you're older. However, there are certain income requirements: You have to earn an income to be able to contribute to a Roth IRA, and you can't contribute more money than you earned. In addition, you can't contribute a Roth IRA if you make more than $177,000 and if you're married and filing jointly; the limit is $120,000 if you file as single, head of household or married filing separately.
It's important to know that distributions or withdrawals from Roth IRA contributions (that is, the dollar amount that you originally invested) are tax and penalty free; however, distributions from earnings are tax and penalty-free only for qualified distributions. For a distribution to be qualified, it must occur at least five years after the Roth IRA was established, and it must occur under the following rules:
- The Roth IRA holder is a least 59 1/2 years old when the distribution occurs.
- The distributed assets are used toward the purchase of a first home, or to build or rebuild a first home for the Roth IRA holder or a qualified family member. Qualified family members include the IRA owner's spouse; a child of the IRA owner and/or of the IRA owner's spouse; a grandchild of the IRA owner and/or of his or her spouse; or a parent or other ancestor of the IRA owner and/or of his or her spouse. This is limited to $10,000 per lifetime.
- The distribution occurs after the Roth IRA holder becomes disabled.
- The assets are distributed to the beneficiary of the Roth IRA holder after the Roth IRA holder's death.
Any withdrawal that doesn't meet one of the guidelines above is considered an early withdrawal and is subject to a 10 percent early withdrawal penalty as well as income taxes on the amount withdrawn. According to the IRS, you may not have to pay the 10 percent additional tax in the following situations:
- The distributions are part of a series of substantially equal payments.
- You have significant unreimbursed medical expenses.
- You're paying medical insurance premiums after losing your job.
- The distributions are not more than your qualified higher education expenses.
- The distribution is due to an IRS levy of the qualified plan.
- The distribution is a qualified reservist distribution.
The bottom line is that a Roth IRA is a wise option for saving for retirement, providing some flexibility if it's necessary to make early withdrawals. Be sure to talk to your financial adviser -- or read on for more information on saving for retirement.