This means that the holder of a Roth IRA will not pay federal income tax on dividends, interest or capital gains generated in the account, as long as the holder is 591/2 years old at the time of distribution and has had the account for at least five years. That can be very advantageous, especially if the account owner is in a higher tax bracket in retirement or taxes are higher in the future.
A Roth IRA is subject to the same contribution limits as a traditional IRA ($5,000 in 2011). Special “catch-up” contributions enable those nearing retirement (age 50 and older) to save at an accelerated rate by contributing $1,000 more than the regular annual limits; $6,000 for those over 50 who qualify.
Another way in which Roth IRAs can be advantageous is that investors can contribute to a Roth after age 701/2 as long as they have earned income, and they don’t have to begin taking mandatory distributions due to age, as they do with traditional IRAs. However, beneficiaries of Roth IRAs must take mandatory distributions.
The Roth IRA also differs from a traditional IRA in that withdrawals of contributions (not earnings) can be made at any time and for any reason; they are tax-free and not subject to the 10 percent federal income tax penalty for early withdrawals. To make a qualified tax-free and penalty-free distribution of earnings, the account must meet the five-year holding requirement and you must be age 591/2 or older.
Otherwise, these withdrawals are subject to the 10 percent federal income tax penalty with certain exceptions which include death, disability, medical expenses in excess of 7.5 percent of adjusted gross income, higher education expenses, and to purchase a first home (up to a $10,000 lifetime cap). However, these withdrawals would be subject to ordinary income tax.
Keep in mind that even though qualified Roth IRA distributions are free of federal income tax, they may be subject to state and/or local income taxes. Eligibility to contribute to a Roth IRA phases out for taxpayers with higher incomes.
Most people don’t know that you can contribute to both a 401(k) and a Roth IRA in the same year. So, if you’re looking for an additional retirement savings vehicle with some unique tax advantages, the Roth IRA could be appropriate for you.