Roth individual retirement accounts (IRAs) are financial instruments designed for retirement savings. Roth IRA funds are taxed prior to being contributed to an account rather than upon withdrawal. Because the Internal Revenue Service has already taken a bite out of contributed funds, the account may be used differently from other retirement instruments. This includes allowing the owner to remove money tax-free under certain circumstances. For this reason, it is often used as a savings account.
Anyone can open a Roth IRA with a bank, credit union or brokerage, provided they have earned income from work. Annual contributions are limited to the amount made working, or $5,000 per year, whichever is less. Those with a higher annual gross income (AGI) have lower limits. In 2010, eligibility to contribute to a Roth IRA phases out once joint income hits $177,000 for joint tax filers, or $120,000 for individual filers. Unlike a standard IRA, contributions are made with taxed income. The holder of the IRA is free to invest the money as aggressively or conservatively as he wishes.
While you'll have to pay capital gains on any earnings you withdraw early, if you withdraw the contributions only, you do not have to pay taxes or penalties on it. For example, if you have contributed $5,000 every year for five years and suddenly have an emergency need for $25,000, you can withdraw that money from your Roth IRA with no penalties or taxes. Anything withdrawn in excess of your contributions total will, however, generally incur capital gains tax and a 10 percent penalty if withdrawn before the account holder is 59 1/2 years old.
Rules for Savings
While a Roth IRA is designed primarily for retirement savings, it can also be used to fund a first-time home purchase and specific educational expenses. You are allowed to withdraw up to $10,000 of both contributions and earnings, tax and penalty free, in order to pay the down payment on a home, provided you opened the IRA at least five years earlier, and it is your first home purchase. You may also withdraw whatever you need to cover your child's college tuition; however, unlike a down payment, you have to pay taxes on any earnings withdrawn in this case.
Parents and guardians are allowed to open custodial IRAs for their employed children. Parents are free to contribute to this IRA if they wish, but under no circumstances can annual contributions exceed the child's annual income, or the annual limit, whichever is smaller. The custodial IRA is turned over to the child upon reaching legal adult age, at which point it is treated like a regular Roth IRA. Custodial IRAs are often used to save money toward college.