What Is A Roth IRA?

By: Mike Power

A Roth IRA is a type of Individual Retirement Account (IRA) that is named after the US senator William V. Roth who was the chief legislative sponsor of this scheme of retirement accounts. Roth IRAs are different from other IRAs in many ways. Roth IRAs were established in the year 1998 (Public law 105-34). Similar to other IRAs, the Roth IRAs are also created to encourage the members of the active work force to save regularly in order to be able to meet their post retirement financial needs. This calls for a disciplined approach on the part of the account owner and requires regular contributions towards the retirement account. It also provides twin benefits to the account owners. The tax-deductible net income is reduced by an amount equivalent to the IRA contribution and the assets also earn returns by way of investment into various financial instruments such as stocks, mutual funds and bonds in which the IRA assets are invested by the account custodian or the administrator.

The biggest advantage enjoyed by a Roth IRA account owner is the tax benefits offered by the government on such schemes.

A Roth IRA accepts contributions from the income earned in a financial year that has already been taxed and allows federal income tax free withdrawals up to the total assets held in the account by the account owner. Even the earnings on the assets in a Roth IRA are often free of federal income tax. This is in contrast to other IRA schemes where the contributions are made from tax-deductible income but the distribution or withdrawal of funds is considered as taxable income. However, the there is an overall limit on contributions to all IRAs including the Roth IRA in a particular financial year. The total of all the contributions in different IRAs should not exceed that limit. Roth IRAs are considered superior to other IRAs because of the tax-free distributions or withdrawals allowed in this scheme of retirement accounts. This has made Roth IRAs very popular in a short span of time.

Another type of Roth IRA called the Self-Directed IRA even allows investments into non-typical assets such as real estate and other exotic investment avenues that are generally shunned by the traditional IRA schemes. The discretion of deciding about the nature of financial instruments in which IRA assets are invested lies with the account custodian or administrator. He can decide the asset classes to which the IRA funds can be allocated. At a more fundamental level, the type of an IRA account held by an investor is also a major deciding factor about the nature of investments made with the corpus. Since IRAs have a low risk profile, volatile instruments are avoided and this makes the common debt instruments such as the US treasury bonds very popular amongst the IRA investors. Next in class are mutual funds that are again considered stable and less volatile compared to investing in stocks with high volatility. Even in equity stocks, the IRA investments take a long-term view of holding the securities and do not indulge in short-term trading.

Retirement
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