How Roth IRAs Work


Roth IRA: a retirement planning option
Roth IRA: a retirement planning option
Copyright © iStockphoto/Pali Rao

Have you ever wondered if you're saving enough of your income today to enjoy your golden years of retirement? There are many ways for Americans to save more for retirement besides simply stashing away extra cash into a savings account -- and who has "extra" cash, anyway?

Retirement programs established by employers are an extremely popular way to save, but there are other alternatives available to subsidize the income generated from an employer's pension plan or Social Security. Unfortunately, funds from pension plans and Social Security alone are rarely enough to grant you the lifestyle in retirement that you may be used to today. Figure out how much you can expect to earn from Social Security when you retire by checking out this retirement calculator.

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While there are many different options for investing for your retirement, individual retirement accounts (IRAs) are a popular choice. There are several different types of IRAs:

  • Employment: Employers have the option to set up IRAs for their employees.
  • Marriage: Married taxpayers may set up IRAs for their spouses.
  • Inheritance: IRAs can be inherited from deceased benefactors, and IRAs can be structured strictly to cover the costs of higher education.

We're going to look specifically at how Roth IRAs work. Fortunately, Roth IRAs include many of the benefits offered in all of these varying types of individual retirement accounts. Before we dive in, let's get familiar with some key words:

  • Contribution: the amount of money you personally invest in a Roth IRA
  • Earnings: money you, the contributor, earn on your investments
  • Heir: a person you designate in your will to receive property when you die
  • Profit: the return you make on your investment

A Roth IRA is similar to a savings account, but unlike a savings account, you invest this money to generate a sizable profit. That profit is then reinvested in the Roth IRA until the maturity date of the account. Because you invest your money into a Roth IRA after taxes, you don't have to pay taxes on the earnings upon withdrawal of the funds at or after the maturity date. This is different from other types of IRAs, 401(k), or 403(b) where you will pay taxes when you withdraw funds. Roth IRAs offer flexibility to the contributor, as funds can be withdrawn prior to maturity without being penalized, (once you meet certain criteria).

Read on to learn more about the history, qualifications, investment options and restrictions of Roth IRAs.

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.

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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.

Roth IRA Contributions: What's Age Got To Do With It?

Starting early can make your investment really work for you.
Starting early can make your investment really work for you.
Copyright © iStockphoto/Clint Hild

Younger people have an advantage when investing in a Roth individual retireme­nt account (IRA) over older Americans who have not taken advantage of this retirement opportunity. (By the way, you don't have to be an American citizen to set up a Roth IRA, but the funds you contribute to a Roth IRA must be earned from United States employment. If you're not an American citizen, you must meet certain guidelines to participate in a Roth IRA.) Think about it-- a 25-year-old can contribute a maximum of $5,000 annually to a Roth IRA. This has the potential to grow significantly over the years. If that same 25-year-old only invested $5,000 one time and made 8 percent annually on the money, he or she would have $7,346.63 after 5 years. Here is what the money would look like over a 10-year period of earning percent interest on an initial investment of $5,000:

$5,000.00 @ 8.0% = $5,400.00 $5,400.00 @ 8.0% = $5,832.00 $5,832.00 @ 8.0% = $6,298.56 $6,298.56 @ 8.0% = $6,802.44 $6,802.44 @ 8.0% = $7,346.63 $7,346.63 @ 8.0% = $7,934.36 $7,934.36 @ 8.0% = $8,569.11 $8,569.11 @ 8.0% = $9,254.64 $9,254.64 @ 8.0% = $9,995.01 $9,995.01 @ 8.0% = $10,794.61

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It seems simple, doesn't it? Imagine how much that initial $5,000 investment will make over the 34 years it will take to reach maturity. Oh, the power of compounded interest!

This is not to say that senior Americans don't benefit from contributing to a Roth IRA-- they certainly do. In fact, Americans who are at least 50 years old can contribute $6,000 annually to a Roth IRA as opposed to the $5,000 contribution limit for those who are under the age of 50. Let's look at the same scenario for someone who is 50 years of age. This person contributes $6,000 to a Roth IRA one time, and at an 8 percent rate of return this is what it looks like over a 10-year period:

$6,000.00 @ 8.0% = $6,480.00 $6,480.00 @ 8.0% = $6,998.40 $6,998.40 @ 8.0% = $7,558.27 $7,558.27 @ 8.0% = $8,162.93 $8,162.93 @ 8.0% = $8,815.96 $8,815.96 @ 8.0% = $9,521.24 $9,521.24 @ 8.0% = $10,282.93 $10,282.93 @ 8.0% = $11,105.56 $11,105.56 @ 8.0% = $11,994.00 $11,994.00 @ 8.0% = $12,953.52

The initial investment more than doubles! Chances are this is not enough for anyone to retire on alone, but if that same 50-year-old contributed $6,000 every year for 10 years, there would be a substantial amount of money available.

Over time, compounded interest can multiply your Roth IRA investment.
Over time, compounded interest can multiply your Roth IRA investment.
Copyright © iStockphoto/Ian Jeffery

Another benefit of contributing to a Roth IRA is that there's no mandatory withdrawal date. This is very important when looking at investment options for yourself. Most retirement investment programs require you to begin making withdrawals on your investment when you reach 70 ½ years of age. The Roth IRA has no such requirement. In fact, you can contribute to your Roth IRA with no intention of ever making withdrawals, and your beneficiaries can inherit the account with no penalties attached. Just imagine how much the 25-year-old's initial $5,000 Roth IRA investment would have grown after 60 years of earning potential. Try out this Roth IRA calculator to learn more.

Qualifications for Roth IRA Participation

Make sure you know the Roth IRA rules.
Make sure you know the Roth IRA rules.
Elizabeth Young/ Stone/Getty Images

Like all good things, there are certain limitations placed on the Roth IRA. This type of IRA was developed specifically with middle-class Americans in mind, so there are obviously income restrictions and contribution limitations, but the expected age limits may surprise you.

Unfortunately, if you're single and have an adjusted gross income (AGI) of $110,000 or more, or if you're married and filing your taxes jointly and have an AGI of $160,000 or higher, you're not eligible to contribute to a Roth IRA. Think about investing those six-figure salaries into other high-return retirement options. Another income rule with Roth IRAs is that you must earn a minimum annual income equal to what you contribute to your Roth IRA. If you earn only $3,000 a year, you can contribute no more than $3,000 annually to your Roth IRA. Everyone else can contribute a set amount, determined by age, annually.

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In 2007, someone under the age of 50 could contribute $4,000 annually to a Roth IRA, and a person at least 50 years of age could contribute $5,000. That limit was increased in 2008 to $5,000 a year for someone who is under 50 years of age. A person who's at least 50 years of age may contribute $6,000 a year to a Roth IRA. Beginning in 2009, these limits will increase by $500 each year to accommodate inflation. So, for example, in 2011, a 35-year-old can contribute $6,000 that year. Then, jumping to year 2012, that same person can contribute $6,500 to a Roth IRA.

The hairy thing about a traditional IRA, like many other retirement plans, is that you're required to start making withdrawals when you turn 70 ½. This can stifle some retirement hopes, since most Americans will work well into traditional retirement age and hope to continue to generate a return on retirement investment options. The good news, however, is that a Roth IRA allows you to contribute as long as you'd like. There's no set withdrawal date. In fact, you can leave your money in this tax-sheltered account as an inheritance for your heirs, with no intention of ever using it for yourself. This is a great benefit for your heirs, since there's no penalty to a beneficiary who inherits a Roth IRA. Your beneficiary can just keep the Roth IRA account and continue to grow it, or he or she can withdraw funds, all tax-free.

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.

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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.

Explore the links on the next page for more great articles and lots of information regarding retirement planning.

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Sources

  • Internal Revenue Service, Department of the United States Treasury: IRA Online Resource Guide - Information about Roth IRAs.
  • Koch, Edward T., et al. The Complete Idiot's Guide to Investing, Third Edition. New York: Penguin Group, 2005.
  • The Washington Post: Members of Congress/William Roth.