Contributing to a Roth IRA can not only help you get ahead of your retirement savings, but is also an investment that, according to many studies, typically performs better than a traditional IRA or 401(k) plan. In this article we’ll explore why this is the case, how to get started as well as some of the drawbacks and risks associated with investing in a Roth. You can visit theislandnow.com to learn more.
How Roth IRAs Work
A Roth IRA is a retirement savings account that allows individuals to invest after-tax money and defer taxes on any income earned from that money until the account owner withdraws it. This differs from a traditional IRA where the contributions are tax-deductible, but you will owe taxes on any earnings withdrawn. A Roth IRA is more advantageous than a traditional IRA in two key ways:
- You pay no taxes on your contributions or earnings whenever you decide to make withdrawals from your Roth IRA.
- The growth of your investments inside your Roth IRA can help you accumulate tax-free income as well in retirement.
Contributions to a Roth IRA are made after-tax. You can make non-deductible contributions to a traditional IRA, but you will be able to deduct any contributions you make to a Roth IRA. This means that if you are in the 15% income tax bracket or lower, a Roth IRA is likely a better option for your retirement savings as long as you have an effective tax rate of at least 15% when your money is withdrawn from the account in retirement.
The Basics of How Traditional IRAs and Roth IRAs Work
When you contribute money to a traditional IRA, you get a tax deduction on the amount you contribute. If your income is $50,000 per year and you contribute $5,000 to an IRA, the government will allow you to deduct that $5,000 from your taxable income. This reduces your taxes by $1,500. The only problem is that when you take the money out in retirement, it will be taxed as ordinary income.
If your other income sources are small during retirement and your withdrawal has exceeded the limits for being taxed as a qualified high-income withdrawal, this can result in being taxed at very high rate on these withdrawals. Therefore, many high-income earners who put money into a traditional IRA favor Roth IRAs.
When you contribute to a Roth IRA, you pay taxes on your contributions up-front. When you make withdrawals from your account in retirement, though, you do not owe any taxes on the earnings from your investments. This can result in your money growing tax-free throughout your retirement years.