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 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.
The advantage of a Roth IRA over a 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 taxes will probably rise in the future, since you're paying now rather than later.
(Of course that's a disadvantage if you think taxes will fall.)
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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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