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A Roth IRA is a retirement savings account that offers tax benefits, thus encouraging taxpayers to save for retirement. Unlike traditional IRAs, you contribute to a Roth IRA with pre-tax dollars which then allows your contributions and earnings to accrue tax-free growth. Essentially, taxpayers won’t be taxed when they take Roth IRA distributions in retirement. 

This is one of the key differentiators of the Roth account. Read on to learn more about this retirement savings option and how it can help you better prepare for retirement.

How A Roth IRA Works

A Roth IRA is a tax-advantaged individual retirement savings plan designed to encourage savers to save more for retirement. With a Roth IRA, individuals can contribute with post-tax dollars. Then in retirement, there are no taxes required on distributions. Essentially, you are paying taxes now to avoid paying taxes in your golden years.

A Roth IRA is different from a traditional IRA, which allows you to contribute pre-tax dollars, meaning those contributions are tax-deductible. With a traditional IRA, you’ll have to pay income taxes on all of the distributions you take during retirement. Additionally, because you delayed your taxation during your working years, the IRS requires all traditional IRA account holders to begin taking required minimum distributions once they reach age 70 ½.  

All IRAs, either Roth or traditional, are accounts that hold investments such as mutual funds, stocks, bonds, exchange-traded funds, and bank savings products. Investors can choose which investments they would like to hold in their accounts. Contributors can open an account with a bank, brokerage firm, or other financial institution.

The Benefits Of A Roth IRA

The biggest advantage of a Roth IRA is that you can contribute with post-tax dollars, allowing your money to grow tax-free. Young people, in particular, benefit because the taxes they pay now will likely be at a lower rate than they will be later in their career (assuming raises in pay and, consequently, a shift to a higher income tax bracket).

Individuals can withdraw on their investments, but not earnings, from a Roth IRA without tax or penalty at any time. Regardless of how long you have held the account or what age you are, the Roth IRA withdrawal you make can be for any amount equal to a sum you contributed. So, if you contribute to your Roth IRA account and later discover you need a little extra cash for an emergency expense, you can use the money you’ve contributed. You can also withdraw money from a Roth IRA, without penalty, in order to pay for qualified expenses. However, income tax may apply to an early distribution of earnings, even on qualified expenses. If you withdraw from a Roth IRA and it’s not a qualified distribution, you may have to pay an additional 10% tax on all early distributions. More on this later.

Another advantage of opening a Roth IRA is that there are no required minimum distributions. While traditional IRAs and 401(k)s are subject to required minimum distributions beginning at age 70 ½, Roth IRAs are not. This makes them an especially good option to use as a way to pass money on to heirs. Once a Roth IRA account holder turns 59½, and has held the account for at least 5 years, they can begin taking distributions from a Roth IRA without paying federal taxes. 

Eligibility Requirements And Maximum Roth IRA Contributions

Anyone with earned income can open and continue contributing to a Roth IRA, regardless of age. Currently, the contribution limit for 2019 is $6,000 per year or $7,000 per year for those who are 50 years or older. However, eligibility and contribution limits depend on variables such as filing status and income. But keep in mind, maximum Roth IRA contributions cannot exceed one’s earned income.

Image of a table that details different contribution limits for Roth IRAs depending on filing statues and modified AGI.

 

For those who have a spouse who doesn’t earn an income, there is an option to open a spousal Roth IRA. With the spousal Roth IRA, the working spouse can contribute to a Roth IRA account in the name of the non-working spouse. To make a spousal Roth IRA contribution, the working spouse’s income must exceed or equal the contribution amount for both accounts. So, for 2019 married couples can contribute up to $12,000 annually and $14,000 if they are over 50 years old.

Also, contributors who earn too much to qualify may set up a “backdoor Roth IRA” by setting up a traditional IRA and then converting it to a Roth IRA. There are one-time tax implications associated with this approach. It’s important to take precautions when taking this route, to ensure that federal law is not violated. It’s wise to partner with a tax advisor and a financial planner to make sure you are following the appropriate rules and regulations garnered by the IRS.

Traditional Vs. Roth IRA: What’s The Difference?

There are a few aspects savers will want to consider when choosing between a traditional versus Roth IRA. Either may be beneficial based on several varying factors. These include your current tax bracket, the tax bracket you expect to be in when you retire, your current financial situation and your personal preference. Here’s a breakdown of a Roth IRA vs. IRA:

You Expect A Higher Tax Bracket In Retirement  

If you assume you will be in a higher tax bracket in retirement, you may find contributing to a Roth IRA more beneficial. Since Roth IRA distributions are not taxable after age 59 1/2, you can benefit from paying taxes now, while you are still classified under a lower tax bracket. This is why people who are early in their careers and generate a lower income may benefit the most from contributing to a Roth IRA. However, no matter which IRA you choose, beginning earlier in life will help you capitalize on compound interest. You accrue compound interest when you reinvest your earnings to generate even more growth. Essentially, you’re earning interest on interest.

But, even if you aren’t in a higher tax bracket in retirement, you can still benefit from the tax advantages of a Roth IRA later in life.

Want To Leave A Legacy To Your Heirs?

If you want to leave a legacy behind to your heirs, a Roth IRA may be the way to go. If you choose not to use your Roth IRA assets in retirement, you can leave the account to your heirs upon your passing. By doing so, your account will continue to accrue tax-free growth. Even though beneficiaries will have to take distributions from the account, they can stretch them over the span of their lifetime. Keep in mind, you must contribute to your account for 5 years or more for your heirs to qualify for tax-free distributions in the future.

With traditional IRAs, beneficiaries must pay taxes on all distributions. If you are a non-spouse beneficiary, you may have to start taking distributions the year after the account holder passes away. But if you’re the spouse of the account holder, you can roll the funds into an inherited IRA and delay your distributions until you reach 70 ½.  

Want The Option To Convert Your IRA Account?  

For those who think taxes will rise, you can open a Roth IRA now and convert your assets. This allows you to lock in your tax rate on the balance of your conversions. Employees who have the option of investing in Roth retirement plans such as a Roth 401(k) can also open a Roth to convert their assets. In doing so they can escape taking required minimum distributions once they reach age 70 ½. 

Roth IRA Withdrawals

As previously mentioned, there are qualified and non-qualified distributions from a Roth IRA. Account holders may withdraw contributions without tax or penalty at any time, but earnings on the investment will only be considered “qualified” under certain circumstances. Here’s a breakdown of what you can expect from both qualified and non-qualified distributions.

Qualified Distributions From A Roth IRA

When it comes to taking out your Roth IRA earnings, it must have been at least 5 years since the account holder first opened a Roth IRA andyou have met one of the following conditions:

  • The account holder is at least 59 ½ at the time of distribution.
  • The account holder (or a qualified family member) uses the assets to purchase a first home. Reiterate the lifetime maximum of $10,000.
  • The account holder becomes disabled.
  • The distribution of assets is to an heir after the account holder’s death.

Non-Qualified Distributions From A Roth IRA

Withdrawals that do not meet the above criteria classify as non-qualified and may be subject to taxation and a 10% early-distribution fee. But there are some exceptions, including:

  • To pay for unreimbursed medical expenses that exceed 10% of the account holder’s adjusted gross income for the year.
  • To pay for medical insurance if the account holder loses their job.
  • To pay for qualified expenses related to higher education.
  • The distributions are part of a series of substantially equal payments.
  • To pay medical insurance premiums during a period of unemployment.
  • To pay for an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.

Getting Started: How To Open A Roth IRA

Now that you understand the benefits of a Roth IRA account, you may be wondering how to open one. Here are a few simple steps:

  1. Determine if you’re qualified to open an account. As stated above, you must meet the income requirements in order to contribute to a Roth IRA. Currently, if you earn $203,000 or more a year each year, and you file jointly, or you earn $137,000, and you file as an individual, you may not qualify. It’s important to note that even if you qualify this year, income limits may change for next year. So, keep an eye out and verify you qualify every year.
  2. Decide where you should open your account. If you already work with a financial advisor, you may be able to open an account with them. However, if you don’t have a relationship with a financial professional, you may be able to open a Roth IRA account at almost any financial institution. When searching for a financial institution, it’s wise to review and compare fees, trading costs, type of investments offered and level of customer service.
  3. Complete your new account paperwork. Once you have selected a financial firm, you’ll need to complete the new account paperwork. Most likely you’ll need your driver’s license or other photo ID, Social Security number, address of your employer and any other personal information that the firm needs to open the account. Additionally, you may want to provide your savings or checking account number and routing number so you can transfer funds into your new Roth account.
  4. Select your investments. While the financial firm will help you open your account, you’ll need to select the investment you would like to hold. Many firms will either let you select your own investments or allow you to choose from one of their custom-designed portfolios. You may also have the option to work with a financial planner or advisor who can help customize a suitable investment mix that may assist you in achieving your financial goals.
  5. Establish a contribution schedule. If your bank allows, you can establish an automatic transfer from your bank account to your Roth account. This allows you to not have to think about making contributions since it’s already done for you. You can establish your own contribution schedule. Keep in mind, you can even make the entire contribution limit amount after April 15. Since there are no tax advantages for delaying contributions, contributing right away will allow your money to start working for you at a faster pace.

If you don’t have one already, you may also want to consider opening a 401(k) instead of – or, ideally, in addition to – a Roth IRA. If your company offers a 401(k) plan, you can take advantage of tax-deductible contributions. Also, your company may offer a match program. This means that they may contribute an additional percentage up to a certain amount of your contribution percentage. For example, if you contribute 3% of your salary toward your 401(k) plan, they may match up to 3% as well. Any additional help you can get saving for retirement will be extremely beneficial in the future.

Essentially, by utilizing multiple retirement savings vehicles, you can create a strategy to help minimize your tax burden in retirement. Doing so will help you boost your current retirement savings rate during your career.

The Bottom Line

Whether you have another retirement account or not, opening a Roth IRA can offer some tax advantages. Paying income taxes on the contributions you make now can help ease some of your tax obligations in retirement. A Roth IRA also enables you to secure your finances for your heirs.

While a traditional IRA may cause your benefactors the stress of paying taxes, a Roth IRA will provide financial security without frustration. Since many Americans struggle to save for their golden years, capitalizing on methods today may ease the stress of managing your finances in later years is a worthwhile endeavor. If you’re seeking other resources, visit our personal finances section at Rocket HQ today.

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This Post Has 5 Comments

  1. It, s really very nice. it’s very helpful for those peoples who don’t have knowledge about retirement savings account and tax benefit. Thank you for posting this.

  2. Hello, would you mind if I printed multiple copies of this article for a jail program I volunteer with? The inmates had questions about 401Ks, investments, insurance, etc. Your article is nicely written in plain English. Thank you so much

  3. The statement, “One of the main advantages of a Roth IRA is that withdrawals are tax-free, without penalty, and can be done at any time.” is misleading (paragraph #3, sentence #2). It is true only if the withdrawals are done for specifically allowed reasons; allowed withdrawal amounts can also be limited, even for allowed reasons; and it is true only if no earnings are withdrawn, only contributions.

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