A Roth IRA is an Individual Retirement Account that provides tax-free growth.
As a result, it's the simplest - and potentially the most effective - sheltered account imaginable.
The Roth IRA Tax Advantage
Like a deductible IRA, Roth gives you the advantage of getting taxed only once, rather than twice (or more) as with a regularly-taxed investment account.
Here is a summary of how it works:
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Regularly-Taxed Account
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Deductible IRA
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Roth IRA
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You pay income tax, and then make your contribution with post-tax dollars
Your principal may be subject to taxes on dividends and capital gains as it grows
You pay capital gains tax on your gain at withdrawal
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You get a tax deduction, essentially letting you deposit pre-tax dollars
Your principal grows tax-free
You pay income tax on the entire amount of your withdrawal
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You pay income tax, and then make your contribution with post-tax dollars
Your principal grows tax-free
You pay no further taxes on withdrawal.
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The advantage of a Roth IRA over a regularly-taxed account is obvious.
Either way you pay income tax up front.
But with Roth, you're then done paying taxes; with a regular account you're just getting started.
This calculator lets you trace "one piece of money" to see what happens under the three scenarios:
Note: the tax loss to the regular account during the growth period is not shown, because it depends on too many variables.
See this page for some guidance.
The advantage of a Roth IRA over a traditional deductible IRA is almost obvious:
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Roth is simple: it requires no special reporting to the IRS.
(With a deductible IRA you have to report a deduction on your 1040 form when you make a contribution; on withdrawal you report the entire withdrawal amount as taxable income.)
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Roth is flexible: because you've taken care of your tax obligations up front you tend to face fewer restrictions later.
(For example, you don't need to begin withdrawing your money by a set age; with a deductible IRA you're required to start making withdrawals by age 70½.)
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Roth has an extra advantage if you think your taxes will probably rise in the future, since you're paying now rather than later.
(Of course that's a disadvantage if you think your taxes will fall.
Note that your own tax bracket might be lower in retirement than it is while you're working, even if tax rates in general go up.)
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Roth has an additional, somewhat confusing advantage that it lets you shelter more real money:
the same dollar amount, but in post-tax, rather than pre-tax dollars.
(The idea is that a tax deduction isn't "money you're getting back"; it's "money you aren't sheltering".)
This issue is analyzed, in more detail than you probably want to see, in a sidebar article.
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