How Roth IRAs Work

by Francie Adkins

Have you ever wondered if you're saving enough of your income today to enjoy your golden years of retirement? There are many ways for Americans to save more for retirement besides simply stashing away extra cash into a savings account -- and who has "extra" cash, anyway?

Copyright © iStockphoto/Pali Rao
Roth IRA: a retirement planning option

Retirement programs established by employers are an extremely popular way to save, but there are other alternatives available to subsidize the income generated from an employer's pension plan or Social Security. Unfortunately, funds from pension plans and Social Security alone are rarely enough to grant you the lifestyle in retirement that you may be used to today. Figure out how much you can expect to earn from Social Security when you retire by checking out this retirement calculator.

While there are many different options for investing for your retirement, individual retirement accounts (IRAs) are a popular choice. There are several different types of IRAs:

• Employment: Employers have the option to set up IRAs for their employees.
• Marriage: Married taxpayers may set up IRAs for their spouses.
• Inheritance: IRAs can be inherited from deceased benefactors, and IRAs can be structured strictly to cover the costs of higher education.

We're going to look specifically at how Roth IRAs work. Fortunately, Roth IRAs include many of the benefits offered in all of these varying types of individual retirement accounts. Before we dive in, let's get familiar with some key words:

• Contribution: the amount of money you personally invest in a Roth IRA
• Earnings: money you, the contributor, earn on your investments
• Heir: a person you designate in your will to receive property when you die
• Profit: the return you make on your investment

A Roth IRA is similar to a savings account, but unlike a savings account, you invest this money to generate a sizable profit. That profit is then reinvested in the Roth IRA until the maturity date of the account. Because you invest your money into a Roth IRA after taxes, you don't have to pay taxes on the earnings upon withdrawal of the funds at or after the maturity date. This is different from other types of IRAs, 401(k), or 403(b) where you will pay taxes when you withdraw funds. Roth IRAs offer flexibility to the contributor, as funds can be withdrawn prior to maturity without being penalized.