Retirement For Beginners: The Roth IRA Explained
Roth IRAs offer tax-free growth on your retirement investments and significant tax benefits.
If you are thinking about contributing to a Roth IRA, here is what you need to know.
Before We Look at the Roth IRA, Understand a Traditional IRA.
A Traditional IRA is a tax-deferred retirement savings account because any income tax or capital gains tax generated during the life of the account is not paid until you withdraw your savings. The taxes are deferred to a later date.
You only pay taxes when taking withdrawals in retirement. This is hugely beneficial because deferring taxes allows compound interest to work its magic, allowing your savings to grow faster than if it was sitting dormant in a taxable account.
How is a Roth IRA Different From a Traditional IRA?
The main difference between a Roth IRA and a Traditional IRA is the difference in tax advantages. With Roth IRAs, you pay taxes on contributions now, and enjoy withdrawing your money tax-free in retirement.
With a Traditional IRA, there are no taxes paid upfront or during the life of the account — taxes are owed when you withdraw your money in retirement (or if you take out your money before retirement, which results in steep penalties).
Who Can Contribute to a Roth IRA?
Anyone who has earned income and meets the salary requirements can deposit money into a Roth IRA. Eligibility is phased out for single individuals earning more than $122,000, or married couples earning more than $193,000 combined.
If you watched my Instagram video where I spelled out The Budget Mom’s 9 Freedom Steps, you know the Roth IRA is not the best fit for me because of my tax bracket. I pay a high tax rate, and when I retire, I expect to be in a lower tax bracket.
So, for me, I can invest money tax-free right now in a Traditional IRA. When I withdraw it, I will pay taxes, but my rate should be lower.
While a Roth IRA is not the best choice for me, it might be a great choice for those who are in a lower tax bracket and expect to be in a higher one when they retire.
If you start investing early, you are more likely to be in a lower tax rate making far less income than when you are ready to retire. In this case, a Roth IRA might be the right choice. A lot of people max out an employer-matched retirement program and then contribute to a Roth IRA.
Roth IRA contributions are due by your tax filing deadline, which usually falls on Apr. 15. Something to keep in mind — if you make a contribution between January and April, you must specify whether the deposit goes into the current calendar year or the previous tax year.
How Can You Open and Invest in a Roth IRA?
There are two simple steps to starting a Roth IRA.
- First things first, decide whether you are a hands-on investor. If the idea of choosing your own investments appeals, then go with a broker. If you are of the set-it-and-forget-it mindset, then a robo-advisor might be for you.
- The next thing you must do is select your investments. A broker can help you with low-cost mutual funds and exchange-traded funds. A robo-advisor will pick the investments for you based on your goals and target dates. These decisions will have an impact on the portfolios selected. An “aggressive” investment scenario involves a high percentage of stocks, and a “conservative” one would seek a less volatile investment plan.
A robo-advisor or online broker can help you with the process in just a few steps. Have all the information you need, a clear idea of which investment drivers you want, and a chosen beneficiary. All in all, opening a Roth IRA should be a reasonably quick process.
How Much Can You Contribute to a Roth IRA?
Total annual contributions for your Roth IRA in 2020 is $6,000 if you are under 50. And if you are 50 or older, there is a catch-up amount, bringing the maximum annual contributions to $7,000. If you are over 50, then it is good to take advantage of the catch-up provision.
When Can You Take Money Out of a Roth IRA?
Withdrawals from a Roth IRA must be taken after age 59 1/2 and after a five-year holding period. The five-year rule requires the investments to be held for five years, and the start date is Jan. 1 of the year in which you made your first Roth IRA contribution.
If you need to make a withdrawal before 59 ½ and the amount exceeds your contributions, you will face a 10% early withdrawal penalty, and you will be taxed at your current rate. However, there are exceptions to the early-withdrawal penalty, such as first-home purchase and college expenses. Paying for unreimbursed medical expenses or health insurance are two other exceptions for the early withdrawal penalty if you are employed.
Required Minimum Distribution
There are no required minimum distributions (RMD) for those who have a Roth IRA. However, your beneficiaries may need to withdraw funds to avoid penalties. This provides an incredible opportunity to leave your savings to grow tax-free for your heirs.
What are the Benefits of a Roth IRA vs. a Traditional IRA?
Many would agree that the incredible benefits of a Roth IRA trump those of a Traditional IRA. Outside of the very affluent, the Roth IRA serves up great tax benefits, flexibility where accessing your money is concerned, and no RMD upon retiring. These are serious benefits, and for many, the Roth IRA is the way to go. But for the sake of comparison, here are some of the significant differences between a Roth IRA and a Traditional IRA.
Roth IRA early withdrawal rules are more flexible.
Early withdrawal rules are far more flexible with a Roth IRA, but in a perfect world, early withdrawals would not be necessary. If it becomes necessary, the Roth IRA allows you to withdraw contributions — that is, the money you put into the account without being taxed or penalized. So, if you contributed $2,000 and your Roth IRA was now valued at $3,500, you will not be penalized or taxed if you withdrew $2,000 or less — the amount of your contributions.
However, if you withdraw from a Traditional IRA before retirement, the IRS will hit you with a significant 10% early withdrawal penalty — with taxes paid at your current income tax rate. This is because you invest pre-tax dollars into a Traditional IRA.
Roth IRA has fewer restrictions.
For retirees, the Roth IRA has fewer restrictions and no RMD – something to seriously consider if you are in a position to allow your savings to grow untaxed for future heirs.
A Traditional IRA has mandatory distributions at age 72. Keeping money invested without forced distributions in a Roth IRA makes it easier to pass on wealth to the next generation. A Roth IRA has no requirements that money must be withdrawn.
Roth IRAs benefit younger people in lower tax brackets.
The sole advantage of a Traditional IRA is in the upfront tax break it offers most people. It makes saving for high earners a no-brainer because the tax savings each year brings down taxable contributions. However, the tax burden will present itself in retirement — so unless you really need a tax break, the Roth IRA is an excellent option, that is, if you qualify.
And there is no question that the Roth IRA is especially ideal for young people with salaries in the lower range — given that they have decades to grow their savings. Add to that, most early years of earning a salary comes with a lower tax bracket. This makes a Roth IRA savings account an especially great thing for the young as they save for retirement.
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Note: This article originally appeared at The Budget Mom.
Category: Personal Finance
