Roth IRAs are gaining attention from consumers, and with good reason. Many financial advisors view the Roth IRA as the Swiss-army knife of a good financial plan; it can help some people accomplish many goals. But how does a Roth IRA work? Let's go over a few basics:
1) First, money enters a Roth IRA "after tax." This means you invest money that already had taxes taken out. You don't receive any tax break for putting money into a Roth IRA. With a traditional IRA, you may receive a tax deduction for putting money into it.
2) Money, including the earnings, can potentially be withdrawn tax-free from the Roth IRA. These tax-free withdrawals are called qualified distributions. There are limitations relating to your age and how long the Roth IRA account was open, so review with your tax advisor to understand which distributions or withdrawals may be tax-free.
3) Finally, taking cash out is easy and might be available before retirement. If life events create a need for funds early, Roth IRA investments may be distributed for qualified education, first time home purchase, or if you become disabled according to IRS code. Again, consult with your tax advisor to determine if you qualify for a Roth IRA, and tax treatment of any withdrawals.
People often ask which is better for retirement, an IRA or a Roth IRA? That's like asking if you purchase a minivan or a pickup truck. Some people need a minivan, but not a pickup truck. Some people need both. Each person's situation is unique. Here is one way to remember the benefits. With a Roth IRA, you pay tax today, but may not pay tomorrow. With a Traditional IRA, you may receive a tax deduction today, but will probably pay tax tomorrow, in the future, when you withdraw the money.