Roth individual retirement accounts were developed in the late 1990s as an alternative to traditional IRAs. Although both types of accounts provide significant tax benefits, Roth IRAs provide most of their tax benefits upon distribution rather than at the time of contribution. Whether a Roth IRA is better for you than a traditional IRA depends on your financial situation. However, even with its negatives, a Roth IRA can provide advantages over a taxable investment account.
No Tax Deduction
The main negative of a Roth IRA is that you can't take a tax deduction for your contributions. Most other retirement plans, such as 401(k) plans and traditional IRAs, allow you to reduce your taxable income by the amount of your contribution, sometimes resulting in dramatic tax savings. For example, if you are in the 35 percent tax bracket, you'd get a $1,750 tax break when you contributed $5,000 to a traditional IRA, as opposed to no deduction at all with a Roth IRA.
If you make too much money, the IRS prevents you from contributing to a Roth IRA. For joint filers, contributions aren't allowed above a modified adjusted gross income level of $179,000 for 2012. For single filers, the limit drops to $122,000. If you qualify to make a Roth contribution, as of 2012 you were limited to $5,000 per year, or $6,000 if you were 50 or older. This is far below the annual 401(k) voluntary contribution limit of $17,000.
Minimum Holding Period
You can't enjoy the chief benefit of a Roth IRA -- tax-free withdrawals -- unless you've held your money in the account for at least five years. Although you can always take out your after-tax contributions without paying additional tax, your earnings will be taxed if withdrawn in the initial five years after you established the account.
Early Distribution Penalty
Taking money out of a Roth IRA before age 59 1/2 is a no-no. The IRS will slap a 10 percent early-withdrawal penalty on you if you do. Additionally, any earnings you take out of the account will be fully taxable, even if you've held the account for more than five years. There are limited exceptions to this penalty, such as withdrawals for a first-time home purchase, disability or death.
- Jupiterimages/liquidlibrary/Getty Images