Generally, you have to pay either income tax or capital gains tax on the money that you make by investing. When you invest in retirement accounts, your investment grows tax-deferred but you still have to pay taxes when you make withdrawals. However, Roth Individual Retirement Accounts (IRA) provide you with the opportunity to create tax-free income. Additionally, you can also lower the tax burden of your estate by investing in a Roth IRA.
Tax Free Income
On an annual basis, you can deposit a portion of your income into a Roth IRA. The money you invest benefits from the same kind of tax-sheltered status that the Internal Revenue Service affords to pretax retirement accounts. You do not pay tax on disbursements from a Roth IRA if you keep the account open for a minimum of five years, and you wait until you reach the age of 59 1/2 before making any withdrawals. Therefore, a Roth IRA provides you with the opportunity for tax-free growth.
The federal government relies heavily on tax revenue to fund its operations. Consequently, the required minimum distribution (RMD) rule means that taxpayers over the age of 70 1/2 must start making taxable withdrawals from their tax-deferred retirement accounts. However, the RMD rules do not apply to Roth IRAs. Furthermore, you can continue to contribute to your Roth IRA regardless of your age, as long as you have some taxable income. You can use a Roth IRA as a tool in your estate planning because the heirs who inherit your Roth IRA do not have to pay income tax on withdrawals.
The IRS uses the first-in-first-out method for calculating your tax liability on Roth IRA withdrawals. This means that you have to withdraw your principal before you can withdraw your earnings. Since you invest after-tax money into a Roth, you can make tax-free withdrawals from your Roth IRA until you have withdrawn an amount equal to the principal. By comparison, traditional IRAs contain pretax money, which means all withdrawals incur income tax and you also have to pay a 10 percent tax penalty if you access the account before reaching the age of 59 1/2. You only have to contend with income tax and the penalty if you access your Roth IRA earnings as opposed to your principal.
While Roth IRAs can provide with many benefits, your contributions are limited by IRS rules. As of 2011, annual Roth contributions are capped at $5,000, although people aged 50 or older can deposit up to $6,000. Income limits also apply to Roth IRAs, which means high earners cannot open a Roth IRA. However, you can get around both the income and contribution limits by converting money held in a traditional IRA into a Roth IRA. When you do this, you have to pay income tax on the money that you convert, but your funds can then grow tax-deferred inside the Roth IRA. You avoid having to pay taxes on your future earnings that would have been fully taxable if you kept the money in the traditional IRA.
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