The Roth individual retirement account is a retirement plan with a huge tax benefit. As of 2012, you can invest up to $5,000 each year into this account. When you invest in a Roth IRA, you will not owe any tax on your reinvested dividends and capital gains. However, to get this tax savings, you need to keep your money in the account until you turn 59 1/2.
When you invest in a Roth IRA, you don't get a tax deduction for your contribution like you do with the the traditional IRA. Instead, the Roth IRA saves your tax benefit for retirement. When you take money out of your Roth IRA after you turn 59 1/2, the entire withdrawal is tax-free. You never pay taxes on your investment gains. Other retirement accounts only delay taxation on your investments. When you take money out of a traditional IRA, the entire withdrawal is taxable.
Reinvested Dividends and Capital Gains
When you hold stock in a regular brokerage account, you owe taxes on your dividends and capital gains immediately. It doesn't matter whether you keep the money in your account or cash out; the IRS still taxes your earnings as income that year. If you earn a dividend or a capital gain in your Roth IRA, you can reinvest the gains and not owe any taxes. As long as you keep the money in your Roth IRA, you won't owe anything to the IRS.
The Roth IRA offers its tax benefits to help people save for retirement. You're not supposed to take your money out before you turn 59 1/2. If you need to take money out before then, you are taking an early withdrawal. You can take out your original contributions without any extra costs, because this was after-tax money. However, if you take out your investment gains before you turn 59 1/2, it gets expensive. The IRS charges income tax plus a 10 percent early withdrawal penalty on any investment gains taken out of your Roth IRA before retirement.
There are a few times when you can take your investment earnings out of your Roth IRA and avoid the 10 percent penalty. You can take money out if you become permanently disabled and can no longer work. You can also use your Roth IRA earnings to pay for your college tuition or the college tuition of a family member. Or you can take out up to $10,000 of earnings from your Roth IRA to buy your first home. These withdrawals avoid the 10 percent penalty, but they are subject to income tax.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.