What is a Roth IRA?
AKA Pay Now, Withdraw Tax-Free Later
Individual retirement arrangements, also known as Roth IRAs, are a type of retirement savings account that allows you to grow your money tax-free. It is funded with after-tax dollars, which means you pay income taxes on the money before contributing it. There are no required minimum distributions (RMDs), so you can continue adding to your Roth IRA balance as long as you're earning income.
A Roth IRA is a type of Retirement Account. The “IRA” stands for Individual Retirement Account. A Roth IRA allows you to get tax advantages on money that you put away for your future. You put money in that’s “after tax”. I.e. you’ve already paid the tax. That money then grows tax free.
A Roth IRA works similarly to a traditional IRA, except that you put money into it after taxes have been deducted. In other words, you pay taxes on your investment up front, let your money compound, and then your withdrawals in retirement are tax-free.
All typical Roth IRA contributions must be made in cash (including checks and money orders); no assets or property can be used. The Internal Revenue Service (IRS) sets annual limits on how much money can be put into any type of IRA, and the amounts are adjusted on a regular basis. The traditional and Roth IRA contribution limitations are the same. These limits apply to all of your IRAs, so you can't contribute more than the maximum amount in any of them. Also, you can only add money if your modified adjusted gross income (MAGI) is below a particular amount.
Here’s the basic life cycle of a Roth IRA:
- Open an account
- Choose your investments
- Contribute after-tax money to your account (i.e., from your bank account)
- Leave your money there so that it can grow
- Hit retirement
- Take withdrawals as needed (and pay no taxes on your withdrawals)
Investments That Are Allowed in a Roth IRA
The best part of a Roth IRA account is the tax-free growth. But it’s not growing if it’s sitting in cash! In addition to simply funding your account, you need to decide how you’re going to invest those funds.
A Roth IRA offers a wide range of investment possibilities, including mutual funds, equities, bonds, exchange-traded funds (ETFs), certificates of deposit (CDs), money market funds, and even cryptocurrency, once the funds have been contributed.
It's important to note that you can't put cryptocurrency into your Roth IRA due to IRS regulations. However, the recent introduction of "Bitcoin IRAs" has resulted in the creation of retirement accounts that allow you to invest in cryptocurrencies.
The IRS also lists other assets not eligible in an IRA, such as life insurance contracts and derivative trading, as well.
If you want the most investing alternatives, one could consider a Roth self-directed IRA (SDIRA), which is a type of Roth IRA in which the investor oversees their assets rather than the financial institution. These open up a whole new world of financial opportunities. You can own assets that aren't generally part of a retirement portfolio in addition to the standard investments (stocks, bonds, cash, money market funds, and mutual funds). Gold, Investment real estate, partnerships, tax liens, and even a franchise business are among your investment options.
Opening a Roth IRA
A Roth IRA must be opened with a financial institution that has been approved by the IRS to offer IRAs. Banks, brokerage firms, federally insured credit unions, and savings and loan associations are among them. It’s been found that individuals typically open IRAs through brokers. For a tax year, contributions must be made by the IRA owner's tax-filing date. This is usually the 15th of April of the following year unless the IRS makes certain changes.
Want to get started right away? Speak with an advisor at Vincere Wealth Management and get an in-depth plan suited just for you.
When it comes to choosing a Roth IRA provider, your risk tolerance and investment preferences will play a role. If you intend to be an active investor who makes a lot of trades, you should look for a provider with cheaper trading expenses. If you leave your investments alone for too long, some providers will charge you an account inactivity fee. Pay close attention to the account's specific criteria. The minimum account balances for some providers are higher than for others.
In general, the optimum time to start a Roth IRA is when you're younger, since your earnings make you more likely to be eligible. Getting a head start on your Roth IRA means you'll have more time to benefit from compound interest.
Are you ready to open a Roth IRA? The team at Vincere Wealth, can help you find a plan that is suited to you. Connect with an advisor here.
Steps to opening a Roth IRA
You can open a Roth IRA at a brokerage account online. You'll need to provide personal information to the brokerage, such as your name, date of birth, and Social Security number. You'll also need to provide a funding source for making contributions. After you've opened your Roth IRA, you may start picking investments.
What Can You Contribute to a Roth IRA?
Each year, the Internal Revenue Service (IRS) sets limits on how much you can put into all of your IRAs, not just your Roth IRA. Contributions must be made by the IRA owner's tax filing deadline each year. The following year's date is usually April 15th. To contribute to the tax year 2021, one has until April 18th, 2022 to do so.
To be qualified for a Roth IRA, you must have earned income. You can never contribute more to your IRA than your earned income in that tax year.
Salaries, bonuses, commissions, consulting gigs, and small company income are all included. It is normally any sum recorded in Box 1 on a Form W-2 or a 1099 for an individual. If you're 49 years old or younger in 2022, you can only contribute up to $6,000 to an IRA. You can contribute up to $7,000 per year if you're 50 or older.
Use this Roth IRA calculator to see how much you can contribute.
Who’s Eligible for a Roth IRA?
Anyone with earned income can contribute to a Roth IRA as long as they meet certain filing criteria and have a modified adjusted gross income of less than $100,000. (MAGI). Those whose annual income exceeds a specific threshold, which the IRS modifies on a regular basis, are no longer eligible to contribute. The data for 2021 and 2022 is shown in the graph below.
Here’s how it works: Anyone earning less than the ranges shown for their suitable category can contribute up to 100% of their remuneration or the contribution maximum, whichever is smaller.
Individuals in the phaseout range must deduct their income from the maximum level and divide that by the phaseout range to find out what proportion of $6,000 they are allowed to contribute.
The Spousal Roth IRA
A spousal Roth IRA is an individual retirement account that belongs to a non-income earning spouse.
Because the IRS requires IRA contributions from taxable income, a non-earning spouse would otherwise be unable to contribute to a Roth IRA. The Spousal Roth IRA is an exception that allows non-earning spouses to deposit into a tax-advantaged retirement account with tax-free distributions later on.
Roth IRA Withdrawals: Qualified Distributions
You can take tax-free and penalty-free withdrawals from your Roth IRA at any time. If you withdraw only the amount you put in, regardless of your age or how long it has been in the account, the distribution is not deemed taxable income and is not subject to penalty.
When it comes to withdrawing account earnings, there is a catch: any returns that the account has generated are taxed. To be considered a qualified distribution, the account earnings must be distributed at least five years after the Roth IRA owner established and financed their first Roth IRA, and the payout must meet at least one of the following criteria:
- If you’re under 59½ and the account is less than five years old, withdrawals of earnings can come with a 10% early withdrawal penalty and will be subject to taxes. The penalty can be waived under certain qualifying situations, but not the taxes.
- If you’re under 59½ and you’ve had the account for at least five years, earnings withdrawals will be subject to taxes unless you meet one of the exceptions.
- If you’re over 59½ but haven’t had your Roth IRA for five years yet, your earnings withdrawals will be subject to taxes but not penalties.
- If you’re over 59½ and have had the Roth IRA for at least five years, your earnings withdrawals won’t be subject to taxes or penalties.
Note: Withdrawals from a Roth IRA are made on a first-in, first-out (FIFO) basis, which means that any withdrawals are taken from contributions first. As a result, until all contributions have been deducted, no earnings are deemed touched.
The Five-Year Rule
The 5-year rule refers to three different rules that apply to IRA distributions. It applies in these three scenarios:
1. You’re withdrawing money from a Roth IRA.
The 5-year rule only applies to Roth IRA withdrawals of investment earnings. Regardless of how long you've had the account or how old you are, you can always withdraw your contributions without paying taxes or incurring penalties.
2. You’re converting a traditional retirement account to a Roth IRA.
Conversions to Roth IRAs are subject to the second 5-year rule. When you transfer money from a standard IRA or 401(k) to a Roth IRA, you must pay income tax on the transfer. You must, however, leave the money in the account for at least five years to receive a tax-free distribution. If you withdraw money before you reach the age of 59 12, you may be subject to an additional 10% penalty.
3. You’ve inherited an IRA from someone who died before the year 2020.
If you inherit an IRA from someone who died on or before December 31, 2019, and hadn't yet reached the age when required minimum distributions (RMDs) begin, you'll be subject to the final 5-year rule. RMDs are required distributions from retirement funds that begin at the age of 72 if you were born after June 30, 1949, and at the age of 70 12 if you were born earlier.
Roth IRA Withdrawals: Non-Qualified Distributions
A non-qualified distribution is a withdrawal of earnings that does not meet the above criteria and may be liable to income tax and/or a 10% early distribution penalty. However, there may be exceptions if the money was used for the following:
- For unreimbursed medical expenses if the distribution is used to pay unreimbursed medical expenses for amounts that exceed 7.5% of the individual’s adjusted gross income (AGI) for 2021 and prior tax years.
- To pay for medical insurance if the individual has lost their job.
- For qualified higher education expenses if the distribution goes toward qualified higher education expenses of the Roth IRA owner and/or their dependents. These qualified expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution and must be used in the year of the withdrawal.
For childbirth or adoption expenses, if they're made within one year of the event and don't exceed $5,000. The contribution is reversed if you withdraw solely the amount of your contributions made during the current tax year, including any gains on those contributions.
Roth IRA vs. Traditional IRA
There are two types of IRAs: traditional and Roth. Both accounts have the same contribution cap. The difference is in how they are taxed. You won't be taxed on your contributions to a regular IRA until you withdraw the funds in retirement. With a Roth IRA, you pay taxes now in exchange for the ability to receive your gains tax-free later.
A good rule of thumb is to think about whether you’ll likely be in a higher or lower tax bracket when you retire, compared with what you’re in now. For example, individuals who anticipate being in a higher tax category when they retire may find the Roth IRA to be more beneficial because the total tax avoided in retirement will be larger than the current income tax. As a result, Roth IRAs may benefit younger and lower-income workers the most.
Investors who start saving with an IRA early in life benefit from compound interest's snowball effect: their investment and earnings are reinvested, which generates additional earnings, which are reinvested, and so on. However, even if you expect to pay lower taxes in retirement, your Roth IRA will provide you with a tax-free income stream.
Roth IRAs have some features that set them apart from traditional IRAs. Here are some differences:
Roth IRA
- Contributions aren’t tax-deductible.
- There are no required minimum distributions and no age limits for contributions.
- Qualified withdrawals are tax-free.
- Your income determines how much you can contribute toward the annual contribution limit.
Traditional IRA
- Contributions are typically tax-deductible.
- Require minimum distributions to be made after age 72.
- You must pay tax on the deductible contributions you made at the time of withdrawal.
- Only annual contribution limits apply.
The Pros of a Roth IRA
While Roth IRAs do not offer employer matching contributions, they do offer a wider range of investment possibilities. Roth IRAs are also a good alternative for people who expect to be in a higher tax bracket as they get older. You can withdraw your contributions (but not earnings) tax-free and penalty-free from a Roth IRA.
Furthermore, you can control how your Roth IRA is invested by opening an account with a brokerage, bank, or other suitable financial institution.
The Cons of a Roth IRA
The main disadvantage of a Roth is that there is a maximum contribution amount, and you can't contribute to a Roth IRA if your income is too high. There are a couple of options for getting around this: You might be able to contribute to a Roth account through your 401(k) plan, and you can convert a regular IRA to a Roth at any income level.
Frequently Asked Questions
Q: Is a Roth IRA or a 401(k) a Better Investment?
While Roth IRAs do not offer employer matching contributions, they do offer a wider range of investment possibilities. Roth IRAs are also a good alternative for people who expect to be in a higher tax bracket as they get older. You can withdraw your contributions (but not earnings) tax-free and penalty-free from a Roth IRA. Finally, you can control how your Roth IRA is invested. By opening an account with a brokerage, bank, or other suitable financial institution. That being said, if you are able to contribute to both, go for it.
Q: Is there a limit on how many Roth IRAs I can have?
The IRS allows you to open as many IRAs as you like, but the amount you can contribute (in the aggregate) is still limited to a yearly cap.
Q: Should I open a Roth or traditional IRA?
Because everyone has different characteristics and benefits, the best IRA for one individual may not be the best for another. On average, younger people have a longer time for their money to grow tax-free in a Roth account. To aid in your decision, examine your present income tax rate as well as your expected future tax rate in retirement. By contrast, traditional IRA donations are tax deductible, but later withdrawals are taxed as income. You should select the account that provides the best tax treatment for your scenario.
Q: Who is eligible to contribute to a Roth IRA?
As long as their adjusted gross income does not exceed IRS limits, anyone with earned income, including minors, can open and fund a Roth IRA. Individuals who have a modified adjusted gross income (MAGI) that exceeds the maximum set by the IRS are not allowed to contribute to a Roth IRA.
Wrapping Up
Roth individual retirement arrangements, also known as Roth IRAs, allow you to contribute after-tax dollars and build a source of tax-free income in retirement. They don't provide current-year tax savings, but your contributions and earnings can grow tax-free. You can withdraw the funds tax-free and without penalty after you reach age 59½ and the account has been open for at least five years.
