We should all know that contributions to Roth IRAs are not tax-deductible. Since you’ve already paid tax on the money you put in, once you begin withdrawing, you don’t pay tax. Sounds good, right?
As with traditional IRAs/401ks, there are two types of Roth accounts: Roth IRAs and Designated Roth Accounts. The latter is similar to a 401k, in that it is typically employer sponsored and has a much higher contribution limit:
|Roth IRA||Designated Roth Account|
|Contribution Limit||$5,500 (for 2013)
$6,500 (if age 50 or older)
|$17,500 (in 2013)
$23,000 (if age 50 or older)
|Participation||Anyone with earned income||Participant in a plan that allows designated Roth contributions|
|Withdrawal Age||59 1/2||59 1/2|
So when would you want to create or contribute to a Roth? Generally if you have excess savings that you would like to invest such that the gains are tax-free. But only when you are unable to fully fund a 401k or IRA.
- Gains: Both capital gains and dividend income are non-taxable
- Distributions are tax-free
- No forced minimum distributions
- Roth assets are excluded from estate taxes
- Losses are typically not tax-deductible
- Early withdrawals (age: <59 ½) are subject to a 10% federal penalty
- Income restrictions for high-earners
- Funds are unavailable for five years after Roth is setup
- Contribution limits are for both Roth & Traditional IRAs
This chart shows the difference in asset valuation assuming you invest $5,500/year over 15 years and a 15% tax bracket for a mix of capital gains+dividends. There isn’t a big difference percentage-wise, but it works out to $10,600, which is a significant sum.
If you are able to invest $17,500/yr into a designated Roth account, then the difference is more significant, almost $34,000 in gains that would otherwise go to the government in taxes. While a Traditional IRA is still the preferred way to save for your retirement, Roth’s can be a good addition when possible.