Question:
I am researching Roth IRA accounts. I found information stating that the money in the account is not tax deductible, but that it does grow tax-free. How is that possible? Do these not mean the same thing?
Answers:
A regular IRA you contribute to and get deductions for your contribution to it (with certain income limitations depending on whether or not you have a retirement program at work). The earnings in the regular IRA grow tax free until you start taking out from your IRA, then the withdrawals are taxed at your income rate when you retire. A ROTH IRA gives you no deduction for the contribution, and grows tax free, but unlike a regular IRA the withdrawals from it are not taxed. You don't get a deduction for contributing to it, so the IRS doesn't tax you on it once you start getting your money back from it.
You cannot deduct the contributions on a Roth from your income taxes. With a regular IRA you reduce your income on your tax return by the amount of your contribution for that year.
You do not have to claim the tax on the interest you earn on a Roth IRA. With a Regular IRA you must claim the income when you draw it out.
The money that you put into a Roth IRA has already been taxed. When you receive distributions (with some restrictions) bot the principle and interest are not subject to tax.
No, they don't mean the same thing AT ALL!
You should discard whatever "research" tools you have been using, they aren't explaining things to you in plain English!
Here's the difference:
A "Regular IRA" is funded with part of your gross pay, so you pay no income taxes on it when you receive it. So it gets invested, and grows until you retire. Then you pay regular income taxes (and no capital-gains taxes) on it when you take it out (after you are 60ish).
A "Roth IRA" is funded with part of your NET pay, so you've already paid income taxes on it. It grows until you take it out (after you are 60ish), and you owe NO additional taxes on it.
Through the miracle of compound interest, the Roth is a FAR better deal if you have 35 or 40 years before you plan to retire, and was invented in part to encourage younger people (many of whom were making NO plans for their future selves) to start saving.
You have 2 choices with IRAs
1) Regular - where what you put in is deductible on your taxes the year you make the contribution BUT all growth will be taxed when you make withdrawals during retirement .
2) Roth - where you do Not get the deduction on your taxes the year you make the contribution (you pay your taxes that year) BUT the growth is not taxed later. . . You do Not pay taxes on the withdrawals .
so
1) You pay the taxes later (including on any growth in value OR
2) You pay the taxes now and avoid taxes on any growth later .
Tax-free means you never pay taxes. Tax-deductible means you can reduce your taxable income. They are not the same.
When you contribute to a Roth 401k, you use money that is being taxed. In particular, you use some of your wages that you pay taxes on, and put it into the Roth 401k account.
As your Roth 401k earns money, that money is not taxed. This is what "tax-free growth" means. But it is even better, since when you take out your money when you retire, all of the distribution (both the money you put in, plus the earnings) is tax-free. You have paid taxes only on the contribution. You never pay taxes on the earnings.
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