How Roth IRAs Work

Many hail the Roth IRA as the greatest tax break ever invented, but there are some important issues to consider before jumping on board.

Like other IRAs, the Roth allows you to accumulate funds for retirement and to enjoy some tax advantages at the same time. While traditional IRAs are tax-deferred, Roth IRAs are designed to be tax-exempt. Traditional IRAs permit you to contribute pre-tax dollars; Roth IRAs accept only already-taxed dollars.

Let's say you're 35 years old and you invest $4,000 of your post-tax income into a Roth IRA each year, starting today. You earn a 10% annual return for the next 30 years until you retire at 65. By then, your contributions would have grown to about $720,000. With a Roth, that's your take-home pay.

With a regular IRA, you would pay taxes on any withdrawals, netting just $612,000 or so, assuming a 15% tax bracket during retirement, or merely $518,400 if you are in a 28% bracket. So far, this is very convincing. But, remember that if the $4,000 had gone directly into a traditional IRA, you would have reaped about $1,120 in tax savings each year in a 28% bracket (and possibly more, if your tax bracket is higher). If that savings is also invested, the total difference between the Roth and the regular IRA becomes slimmer. Still, the Roth is a very compelling proposition to most investors.

The Roth is fully available to individuals who earn up to a certain amount. You can roll over, or convert, your traditional IRA into a Roth one by paying taxes on it, counting the entire value of the account as income.

There are more benefits and limitations to consider before you decide whether the Roth is for you. You can get details from your local tax professional, from the IRS website, and also at the Fool's Tax Strategies, IRAs, and Retirement areas.

And by the way, this is exactly the kind of topic that a financial advisor can help you with. Learn how to find one at our Advisor Center -- and perhaps check out our TMF Money Advisor service, which features customized independent advice from a variety of objective financial experts.

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