Roth individual retirement arrangements were introduced in 1998 to offer an after-tax option for retirement savings. Contributing to a Roth IRA usually won't affect your income tax refund in the current year, but it could save you lots of money on your taxes in the future, making it particularly useful if you think you'll pay a higher tax rate in the future.
Unlike traditional IRA contributions, Roth IRA contributions aren't tax deductible. Therefore, contributing won't decrease your taxable income. For example, if your taxable income is $50,000 and you put $5,000 in your Roth IRA, you'll still be taxed on $50,000 of income. In fact, unless you are eligible for the retirement savings credit, your Roth IRA contributions won't even show up on your tax return.
Retirement Savings Credit
Even though you can't deduct your Roth IRA contributions, you might qualify to use them to claim the retirement savings credit, which would likely increase your tax refund this year. The credit is up to $1,000 and ranges from 10 to 50 percent of your first $2,000 of contributions, depending on your income. However, if you're income is too high or you're a full-time student during at least five months of the year, you're not eligible.
Assuming you invest your Roth IRA well, you get the added benefit of tax-free growth as long as the money stays in the Roth IRA. For example, if you didn't contribute the money to a Roth IRA and just invested it in a mutual fund instead, you'd have to pay taxes on those gains each year. Say you've got $2,000 in gains each year and you pay 20 percent in taxes; you'll be giving up $400 in taxes, leaving you with only $1,600 in gains. Now assume you put that money in a Roth: since it grows tax-free, the full $2,000 stays invested and continues to generate income in the future.
Once you qualify to take qualified distributions, all the money in your Roth IRA can come out tax-free at any time. To do so, you've got to meet two requirements. One, you have to wait at least five tax years after your first contribution. Two, you've got to be either 59 1/2, permanently disabled or taking out up to $10,000 for your first home. If you hadn't invested in a Roth IRA, you'd have more taxable income and a smaller tax refund in the years you're taking out the money.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."