What Is a Roth IRA?
A Roth individual retirement account is a special type of IRA that offers after-tax savings, rather than pretax savings like a traditional IRA. Because you forgo the tax break for contributions that you would receive from a contribution to a traditional IRA, Roth IRAs are especially attractive to people who are paying a lower income tax rate today than they anticipate paying when they take the money out at retirement, according to CNN Money.
Contributing to a Roth IRA
To contribute to a Roth IRA, you must have some compensation during the year, but your total income can't exceed the income limits. Compensation only counts your income from working, like your wages and tips, but not your investment income or income from rentals. As of 2014, you can put in the smaller of $5,500 or your total compensation for the year.
Tax Benefits of Roth IRAs
Roth IRAs offer multiple tax benefits. First, the money grows without being taxed as long as it remains in the account. Second, you won't pay any taxes on the distributions as long as you wait five years after opening the account and you're at least 59 1/2 years old when you take the distribution. Finally, Roth IRA contributions count toward calculating the Saver's Credit -- a tax credit offered for putting money away in a retirement plan -- if your income is low enough to claim it.
Investing With Your Roth IRA
Your Roth IRA isn't an investment by itself -- it's just a special account to hold the money. Once you put the money in the Roth IRA, you can select from a range of options including mutual funds, bank accounts and individual stocks or bonds. You should select your investments based on your risk tolerance and how long you have until retirement. For example, if retirement is two decades away, you have plenty of time to recover from a bad year or two in the stock market. But, if you're anticipating retiring next year and will need the money, a bad year could put a substantial dent in your retirement budget.
Early Withdrawal Perks
With a Roth IRA, you can remove your contributions at any time without paying taxes or penalties. However, if you tap the earnings early, you'll pay taxes and a 10 percent early withdrawal penalty. If an exception applies, like college or graduate school costs, medical insurance while you're unemployed or up to $10,000 to buy your first home, you don't owe the penalty. For example, if over the years you've put in $10,000 and the investments have grown to $12,000, you can take out $10,000 without paying taxes or penalties even if you aren't 59 1/2 years old. But, if you take out the last $2,000, you owe taxes and the 10 percent early withdrawal penalty on that $2,000.