A Roth IRA provides several benefits to retirement investors. Because you contribute after-tax dollars to a Roth IRA, funds invested in the account can grow tax-deferred and tax-exempt until retirement. The account can grow through dividends, interest and capital gains. Tax consequences can occur if the accumulated income is removed from the plan before the specified minimum retirement age.
The Basics of a Roth IRA
A Roth IRA allows an investor to contribute up to set limit each year. The contribution limit can change from year to year, and is also dependent upon the investor's taxable income. The contributions into the plan are not tax-deductible. But the contributions and income accumulated in the plan are not taxable when they are withdrawn after the investor turns 59 1/2 years old. The contributions can be withdrawn earlier without penalty, but the income will attract the penalty and be taxed as ordinary income.
Capital Gains in a Roth IRA
A Roth IRA plan does not differentiate between short-term and long-term capital gains because the gains are never taxed if the investor is 59 1/2 years old or older. If the gains are withdrawn prior to the minimum age, the gains are taxed as ordinary income, which is often a higher rate than the regular tax rate on capital gains. Investors who are confident that they will not have to make an early withdrawal have a distinct tax advantage by investing in capital gains producing assets in a Roth IRA rather than a non-retirement plan or a traditional IRA.
Penalties for Early Withdrawal
If an investor withdraws funds from a Roth IRA before she turns 59 1/2, there may be tax implications, depending on how much is withdrawn. The IRS allows all contributions to be withdrawn without penalty or tax. Contributions are considered to be the first amounts withdrawn. Any amounts above the total contributions represent the income accumulated in the fund and incur a 10 percent penalty and are also taxed as ordinary income. For example, if you contributed $12,500 to your Roth IRA over the years and it is now worth $18,900, you can withdraw up to $12,500 before the minimum age without penalty but, if you withdrew $15,000, $12,500 would be tax-free, but you would pay a $250 penalty on the rest plus include $2,500 in your taxable income for the year.
Roth IRA vs. a Traditional IRA
There are several significant tax differences between a Roth IRA and a traditional IRA. In a Roth IRA, contributions are not tax-deductible and income is not taxable as long as the rules are followed. In a traditional IRA, contributions are tax-deductible and income and contributions are taxable in retirement. This makes Roth IRAs tax-exempt and traditional IRAs tax-deferred. If your tax rate is lower in retirement than when you contributed, there is a partial tax-exemption because your deduction will be higher than the tax on the income.
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