How Does the Roth IRA Work?

by Robert Shaftoe ; Updated July 27, 2017

The Roth individual retirement account was introduced in connection with the Taxpayer Relief Act of 1997 as an alternative to traditional IRA accounts. The changes introduced in the Roth IRA were meant to spur increased saving among individuals, primarily by lowering many of the tax restrictions associated with IRAs. Both types of IRA accounts are meant to provide individuals with accounts to grow their retirement accounts, aided by various tax benefits.

Four of the more significant general characteristics of the IRA that were updated with the introduction of the Roth IRA were:

  1. Contributions: Individuals can make contributions to the Roth IRA at any age; individuals over the age of 70.5 cannot make contributions to traditional IRAs.
  2. Deductibility of Contributions: Roth IRA contributions cannot be used to deduct ordinary income, but a portion of regular IRA contributions may be deducted from ordinary income.
  3. Withdrawals: With the Roth IRA, you will never pay taxes on withdrawals of contributions, regardless of when they occur, but if you withdraw earnings before you reach age 59.5, a federal penalty of 10 percent is applied. With the traditional IRA, a 10 percent early withdrawal penalty is applied to withdrawals of both contributions and earnings.
  4. Required minimum distributions: Unlike Roth IRAs, traditional IRA accounts require you to make minimum distributions from the account after you reach age 70.5.

In both cases, there are limits on the amount of contributions allowed annually. During the 2015 tax year, contributions were limited to $5,500 for individuals under the age of 50, while individuals over the age of 50 could contribute up to $6,500.

Benefits of Investing Using the Roth IRA

The Roth IRA is an important tool that is particularly attractive to individual investors who are interested in actively managing their retirement portfolio. One of the most attractive features of the Roth IRA is that it allows your investment portfolio to grow, and buying and selling do not trigger capital gains tax. The benefits derived from this cannot be understated due to the effects of compounding interest. Even moderate investment returns are magnified by the effects of time when investment returns are continuously reinvested, especially when taxes are not applied. Returns are maximized by the concept of earning interest on your interest.

Opening a Roth IRA Account

You can open a Roth IRA account by confirming your eligibility and completing a new account registration form either online or at a branch of almost any commercial bank, brokerage company, insurance company or investment company. The Roth IRA allows you to participate even if you are already participating in a sponsored retirement account, such as a 401(k), through your employer. You can use the account to build a diversified retirement portfolio made up of stock and bond investments but also alternative investments such as real estate investment trusts. If you already own a traditional IRA or another type of deferred compensation plan, you can convert it to a Roth IRA.

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