Economy & Jobs

Roth IRA Tax Benefits: Getting the Most From This Underused Program

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Americans don’t understand nearly enough about their taxes, and it’s costing them a fortune. In February, NerdWallet released online-quiz results that made this painfully clear. The quiz tested respondents’ basic tax knowledge, and the majority of them failed.

One of the questions that gave people the most trouble was about Roth IRA tax contributions. This is a serious concern because the Roth IRA is an incredibly effective way to save for retirement. It’s important to understand this account’s tax benefits so you can determine whether it will help you reach your retirement goals.

Roth IRA Basics

The Roth IRA is a type of investment account. You add money to it and then invest in stocks, bonds, and mutual funds. Most major brokerage firms that sell investments offer a Roth IRA and can set it up for you.

The 2015 contribution limit for a Roth IRA is $5,500 per year for those under the age of 50 and $6,500 for those aged 50 and over. You can only use this type of account if you file as single or head of household and earn up to $131,000, or are married and earn up to $193,000 combined. The government sets these income limits to make sure the tax benefits go to middle America rather than to the very wealthy. That’s why it’s so disappointing that many Americans don’t understand how this account works.

Roth IRA Tax Advantages

Regular investment accounts require you to pay taxes on your earnings each year, which can drain the return on your investment. Conversely, when you invest through a Roth IRA, you don’t owe taxes on your investment earnings as long as that money stays in your account. Even better, if you wait until retirement to take money out, your investment earnings won’t be taxed at all and you can start making tax-free withdrawals once you turn 59 and a half. This is one of the few ways to earn tax-free income in the United States; the IRS doesn’t often give out this kind of break.

Roth IRA Disadvantages

As great as a Roth IRA account can be, it’s important to note the potential downsides. First, the government set up this tax break to help Americans save for retirement. As a result, you’re supposed to keep your savings in the account until you turn 59 and a half. If you take out your investment earnings before then, you’ll owe income tax plus a 10 percent penalty on the withdrawal. There are several exemptions to this penalty, however, such as total and permanent disability and paying for qualified college expenses.

Another downside is that the Roth IRA doesn’t give you an immediate tax benefit. You don’t get a tax deduction for your contributions like you would from a 401(k) or a traditional IRA. However, in the long run, most people see a greater benefit from using the Roth IRA. While other accounts only delay taxes on income, the Roth IRA gives you a way to completely avoid taxes.

For Americans to reach their retirement goals, they need to make the most of every tax benefit possible. Unfortunately, not enough of us are doing so. Don’t make the same mistake—be sure to take advantage of Roth IRA tax savings.