How does a ROTH IRA work?

The ROTH IRA turns traditional IRA rules upside down.  It is named for Sen. Roth of Delaware who was the chief legislator to propose this type of IRA back in 1997.  So, it has been around for a while but it is definitely gaining in popularity, and rightfully so.

The best analogy to explain a ROTH IRA is the concept of the Seed and the Harvest.   Would you rather pay tax on the seed or the harvest?   The seed represents the dollars you contribute to your IRA over your working life time.  The harvest is that lump sum you have accumulated at retirement time.  So would you rather pay tax on that seed each pay day as you contribute to your account or defer the tax and pay it in retirement on the money as you draw it out?

Most people don’t think of it this way, but Uncle Sam owns at least one-third of your Traditional IRA.  Each time you draw out a dollar from your IRA you first have to pay ordinary income tax, both federal and state, shrinking your net value by the tax you pay.   This is because your contributions are pre-tax meaning you get a tax deduction for the contribution, and you defer the tax on the entire account, the contributions and the growth, until you draw out money in retirement.  This might be okay if you are in a lower tax bracket in retirement, but for many retirees, their tax brackets are the same as when they were working.  And, we are currently in historically low tax brackets and many expect taxes to go up, not down in the future.

The ROTH IRA contribution is not tax deductible.  You pay tax on the money you contribute to a ROTH IRA. But, when you retire and start drawing from the harvest, your dollars received are tax free!  This is a huge benefit.  It is all yours!  So essentially, you never pay tax on the growth on your money.  

With a Traditional IRA if there is anything left at the time of your death your heirs have to pay the income tax when they withdraw the money.  If your heirs inherit your ROTH IRA, they will receive the dollars tax free!  

There is also a mandatory Required Minimum Distribution from your Traditional IRA starting at age 70 and a half and every year after that.  A certain percentage based on a government life expectancy chart must be withdrawn and the taxes paid.  But, there is no mandatory distribution from a ROTH IRA during your lifetime. If inherited there is a mandatory distribution for heirs, because why would the government allow this tax free pot of gold to pass on for generations and accumulate tax free money?  So heirs must start taking annual distributions but those distributions when taken according to the rules are tax free.  

To find out more about a ROTH IRA and whether it is a good strategy for you, call us at 540-772-4545.  

Written by Connie C. Guelich, CFP, AEP, CLU, ChFC.  This represents our views at the time of this writing, and is subject to change.  It is not intended to be personal investment advice.   If you would like to discuss your own account, please don’t hesitate to call us.  We are here to help and welcome your call.