A Roth IRA is an Individual Retirement Account that provides tax-free growth. As a result, it’s the simplest – and potentially the most effective – sheltered account imaginable.
The Roth Tax Advantage
Like a deductible IRA, Roth gives you the advantage of getting taxed only once, rather than twice (or more) as with a regularly-taxed investment account. Here is a summary of how it works:
|Regularly-Taxed Account||Deductible IRA||Roth IRA|
| You pay income tax, and then make your contribution with post-tax dollars Your principal may be subject to taxes on dividends and capital gains as it grows |
You pay capital gains tax on your gain at withdrawal
| You get a tax deduction, essentially letting you deposit pre-tax dollars Your principal grows tax-free|| You pay income tax, and then make your contribution with post-tax dollars Your principal grows tax-free|
The advantage of a Roth IRA over a regularly-taxed account is obvious. Either way you pay income tax up front. But with Roth, you’re then done paying taxes; with a regular account you’re just getting started.
The advantage of a Roth IRA over a deductible IRA is almost obvious:
- Roth is simple: it requires no special reporting to the IRS. (With a deductible IRA you have to report a deduction on your 1040 form when you make a contribution; on withdrawal you report the entire withdrawal amount as taxable income.)
- Roth is flexible: because you’ve taken care of your tax obligations up front you tend to face fewer restrictions later. (For example, you don’t need to begin withdrawing your money by a set age; with a deductible IRA you’re required to start making withdrawals by age 70½.)
- Roth has an extra advantage if you think taxes will probably rise in the future, since you’re paying now rather than later. (Of course that’s a disadvantage if you think taxes will fall.)
- Roth has an additional, somewhat confusing advantage that it lets you shelter more real money: the same dollar amount, but in post-tax, rather than pre-tax dollars. (The idea is that a tax deduction isn’t “money you’re getting back”; it’s “money you aren’t sheltering“.)