Just what is a Roth IRA?

To explain a Roth IRA, you first have to understand a traditional IRA. A traditional IRA is a retirement savings plan that lets employees have income tax deductions for their retirement investments and savings. Once you retire and withdraw that money, it is then taxed. You're deferring your taxes.

Now, a Roth IRA is almost the complete opposite. Basically, retirees can withdraw from their Roth IRA accounts without any tax penalties or being charged any taxes. However, they get no tax deductions up front for making contributions.

Is a Roth IRA right for you?

For some people, the Roth IRA is the perfect choice and allows them to achieve incredible tax savings. For others, it makes little or no difference, and they'd be much better off opting for a traditional IRA.

So, before you choose a Roth IRA, first check whether you're better off with your 401(k). For example, if you have a 401(k) plan, your employer will match your contributions up to a certain level. That's free money which is not taxed and it's hard to pass up. Because of this, many people opt to contribute up to their employee matching maximum and then combine that with a Roth IRA.

But, if you think you'll be in a higher tax bracket by the time you retire, then a Roth IRA could be a great choice. For example, if you're currently paying about 30% in taxes, but you think that tax rate could be more like 40% by the time you reach retirement, you should opt for tax-free income later rather than now.

To estimate your future tax rate, look at your current position - are you at your peak earning potential, or rather are you just starting out in your career and expecting to earn more in the future? If you project that you fall into the latter, then a Roth IRA is for you. However, if you're currently earning at your maximum and expect your tax rate to fall at retirement, then you're better off sticking with a traditional 401(k) plan.

Who is eligible?

The income limitations on Roth IRAs are significantly higher than those for a traditional IRA. With a basic IRA, your income must be $60,000 or lower. With a Roth IRA, a married couple can make up to $160,000.

In the process of learning just what is a Roth IRA, you should also now have an understanding of how the plan works, what its benefits are and how you can optimize your use of this new retirement savings option. Determine whether this or a traditional IRA meets your needs, then make the investment.