Roth IRA is a tax-advantaged, retirement savings account that enables you to withdraw your savings free of tax. It was established in 1997 and was named after a former Delaware senator, William Roth.
Roth IRAs are related to traditional IRAs. The biggest difference between the two is how they’re taxed. Roth IRAs are financed with after-tax dollars; the contributions aren’t tax-deductible. But the money is tax-free once you start to withdraw funds.
Contrarily, Traditional IRA deposits are normally made with pretax dollars; you always enjoy a tax deduction when saving and later pay income tax when you start withdrawing the money from the account during retirement.
This and some other major distinctions make Roth IRAs a nicer choice than traditional IRAs for some retirement savers.
A Roth IRA is an outstanding retirement account where you do pay taxes on money entering your account and do not have to pay tax on all future withdrawals.
If you think your taxes will be higher in retirement than they are presently, then Roth IRAs are best for you.
If you make too much money, you are not welcomed to contribute to a Roth IRA. In 2019, it was $137,000 in annual income for singles and $203,000 for married couples.
In 2020, the limit for singles has grown to $139,00 and $206,000 for married couples.
The amount you are allowed to contribute changes occasionally. In 2019 and 2020, the contribution threshold is $6,000 a year unless you are above 50 years of age. In that case, you can contribute up to $7,000.
Roth IRA is offered by almost all brokerage organizations, both physical and online. So also are most banks and investment companies.
Understanding Roth IRAs
Just like other qualified retirement plan accounts, the money donated within the Roth IRA accumulates tax-free. Nonetheless, a Roth is more unrestrictive than other accounts in various ways. You can continue to make contributions once you (as a taxpayer) pass the age of 70½, as long as you have earned income. The taxpayer is able to retain the Roth IRA indefinitely; no minimum distribution (RMD) is required during the account holder’s lifetime, as you have with 401(k)s and traditional IRAs.
A Roth IRA can be financed from various sources:
- Regular contributions
- Spousal IRA contributions
- Rollover contributions
All regular Roth IRA contributions are to be made in cash (checks included); they are not allowed to be in the form of securities or assets. However, a number of investment options are available within a Roth IRA, once you have contributed the funds, including mutual funds, stocks, bonds, ETFs, CDs, and money market funds.
The IRS restricts how much can be put into any type of IRA, periodically adjusting the amounts. The contribution thresholds are the same for traditional and Roth IRAs.
Opening a Roth IRA
For an institution to offer a Roth IRA, it must be approved by the IRS. These institutions include banks, brokerage companies, federally-insured credit unions, savings, as well as loan associations. Commonly, individuals open IRAs with brokers.
You can establish a Roth IRA whenever you want. Nevertheless, contributions for a tax year must be made by the IRA owner’s tax-filing deadline, which is normally 15th of April of the following year. Tax-filing extensions not applied.
You are to be provided two essential documents when an IRA is established:
- IRA disclosure statement
- IRA adoption agreement and plan document
These contain the basis of the rules and regulations under which the Roth IRA operates and establish an agreement between you (the IRA owner) and the IRA custodians/trustee.
All financial institutions are not created equal. Some IRA providers are of an expansive list of investment options, while others are more restrictive. Also, almost every institution offers a different fee structure for your Roth IRA, which can have a substantial impact on your investment returns.
Your tendency to tolerate risk and investment preferences will play a key role in choosing a Roth IRA provider. If your plan is to be an active investor and making lots of trades, you will want to look for a provider with lower trading costs. Some particular providers will even charge you an account inactivity fee if you leave your investments alone for a long period of time. Some providers have more distinct stock or exchange-traded fund offerings than others; it depends on the kind of investments you prefer in your account.
Concentrate more on the specific account requirements as well. Some providers operate higher minimum account balances than others. If you are planning to bank with the same institution, check if your Roth IRA account has additional banking products. And if you’re planning to open a Roth at a bank or brokerage where you already have an existing account, also check if existing customers enjoy any IRA fee discounts.
Roth IRA Vs. Traditional IRA
Are Roth IRAs Insured?
If you have your account located at a bank, be informed that IRAs fall under a different insurance category other than conventional deposit accounts. Hence, the coverage for IRA accounts is less. The Federal Deposit Insurance Corporation (FDIC) still gives insurance protection up to $250,000 for traditional or Roth IRA accounts, but account balances are merged rather than viewed individually.
For instance, if the same banking customer has a certificate of deposit held within a traditional IRA having a value of $200,000 and a Roth IRA held in a savings account having a value of $100,000 at the same institution, the account holder has vulnerable assets of $50, 000 without FDIC coverage.
What You Can Contribute to a Roth IRA?
The IRS does not only dictate how much money you can deposit in a Roth, but also the type of money you can deposit. Virtually, you can only contribute earned income to a Roth IRA.
For an individual working for an employer, eligible compensation to fund a Roth IRA includes salaries, wages, commissions, bonuses, and any other amount paid to the individual for the services he or she performs. It’s commonly any amount provided in Box 1 of the individual’s Form W-2.
For a self-employed individual or a member of a partnership business, eligible compensation is the individual’s net earnings from their business, minus any deduction allowed for contributions made to retirement plans on behalf of the individual and further reduced by 50% of the individual’s self-employment taxes.
Funds pertaining to divorce (alimony, child support, or in a settlement) is eligible to be contributed.
Now, what sort of funds aren’t eligible to be contributed?
The list includes:
- Rental income or any profit made from property maintenance.
- Interest income
- Pension or annuity income
- Stock dividends and capital gains
You can not contribute to your IRA more than you earned in any tax year. And, as earlier mentioned, you get no tax deduction for the contribution, although you may take a Saver’s Tax Credit of 10%, 20%, or 50% of the deposit, based on your income and life situation.
Who Is Qualified For A Roth IRA?
Anyone earning taxable income can contribute to a Roth IRA. You are eligible as long as you meet specific requirements pertaining to filing status and modified adjusted gross income (MAGI). Those whose annual income surpasses a certain amount, which the IRS modifies periodically, are ineligible to contribute.
The Spousal Roth IRA
One strategy a couple can implement to improve their contributions is the spousal Roth IRA. An individual is allowed to fund a Roth IRA on behalf of his/her married partner who earns insufficient or no income. Spousal Roth IRA contributions are liable to the same rules and restrictions as ordinary Roth IRA contributions. The spousal Roth IRA should be held singly from the Roth IRA of the individual making the contribution, as Roth IRAs can’t be joint accounts.
For an individual to qualify to make a spousal Roth IRA contribution, the following requirements are to be met:
- The couple must be legally married and file a joint tax return.
- The individual who is making the spousal Roth IRA contribution should have eligible compensation.
- The gross contribution for both spouses should not surpass the taxable compensation reported on their joint tax return.
- Contributions to one Roth IRA are not to surpass the contribution limits for one IRA.
Withdrawals: Qualified Distributions
Whenever you want, you are allowed to withdraw contributions from your Roth IRA both tax- and penalty-free. If you withdraw just an amount of the sum you’ve put in, the distribution is not considered taxable income and is not subject to a fee, not minding your age or how long it has been in the account. In IRS-speak, this is called a qualified distribution.
However, there’s a catch when we talk of withdrawing account earnings—any returns the accounts generated. For distribution of account earnings to be qualified for withdrawal, it must have existed for at least five years after the Roth IRA owner has established his/her first Roth IRA and funded it, and the distribution must happen under at least one of the following conditions:
The Roth IRA holder is at least 59½ years of age when the distribution happens.
The distributed assets are used for the purchase – or to build or rebuild – a first home for the Roth IRA holder or an eligible family member (which can be the IRA owner’s spouse, a grandchild of the IRA owner and/or of their spouse, a child of the IRA owner and/or of the IRA owner’s spouse, a parent or other ancestor of the IRA owner and/or of their spouse). This is restricted to $10,000 per lifetime.
The distribution happens after when the Roth IRA holder is disabled.
The assets are distributed to the beneficiary of the Roth IRA holder after the Roth IRA holder is deceased
The 5-Year Rule
Withdrawal of earnings may be liable to taxes and/or a 10% fee, based on your age and whether you’ve met the 5-year rule.
If you meet the 5-year rule:
- Under 59½: Earnings are liable to taxes and fees. You are only eligible to avoid taxes and penalties if you use the cash for a first-time home purchase. Should in case you have a permanent disability, or if you pass away; your beneficiary takes the distribution.
- Age 59½ and older: No taxes or fees.
If you don’t meet the 5-year rule:
- Under 59½: Earnings are liable to taxes and penalties. You may be able to avert the penalty (not the taxes) if you use the money for the purchase of a first-time home, qualified education expenses, unreimbursed medical expenses, if you have a permanent disability, or if you are deceased (and your beneficiary receives the distribution).
- 59½ and older: Earnings are liable to taxes but not penalties.
Whether or not a Roth IRA is more advantageous than a traditional IRA is dependent on the filer’s tax bracket, the tax rate expected at retirement, as well as personal preference.
People who expect to be in a higher tax bracket after their retirement may find the Roth IRA more beneficial since the total tax avoided in retirement will be greater than the income tax paid now. For this reason, younger and lower-income employees may take more advantage of the Roth IRA.
Certainly, by starting to save with an IRA early in one’s life, one makes the most of the snowballing effect of compound interest, that is, your investment and its earnings are reinvested and yield more earnings, which are again reinvested and so on.
Note: If you are more interested in tax-free income when you retire than in a tax deduction now that you contribute, consider opening a Roth IRA over a traditional IRA.
Of course, even if you are expecting to have a lower tax rate in retirement, you’ll still get a tax-free income stream from your Roth. This is not a bad idea.
If you do not need your Roth IRA assets in retirement, you can leave the money to accumulate indefinitely and pass the assets over to heirs tax-free upon death. Better still, while the heirs are to take distributions from an inherited IRA, they can stretch out tax deferral by receiving distributions depending on how long they are expected to live.
On the other hand, traditional IRA beneficiaries do pay taxes on the distributions. Again, a spouse can roll over an inherited IRA into a new account and not have to start collecting distributions until age 70½.
Some individuals open or convert to Roth IRAs due to the fear of an increase in taxes in the future, and this account allows them to stay in the current tax rates on the balance of their conversions.