Roth IRAs are after-tax retirement accounts, in contrast to traditional IRAs and most employer-sponsored retirement plans, which are tax-deferred. Because of their unique tax structure, Roth IRAs have several advantages over other types of retirement accounts. Here's a rundown of what beginners should know before opening their first Roth IRA.
What is an IRA?
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IRA stands for individual retirement account (or individual retirement arrangement, depending on the source). An IRA is a tax-advantaged investment account designed to help Americans save for retirement.
Money invested within an IRA grows over time on a tax-deferred basis. This means that you won't get a tax bill for capital gains, dividend, or interest income taxes for investments that remain in an IRA. You only pay tax on the money in an IRA once -- when you withdraw it or when you contribute it. And this is the major difference between the two main types of IRAs.
Roth versus traditional IRAs
As I just mentioned, the main difference between Roth IRAs and traditional IRAs is the tax treatment of contributions and withdrawals.
With a traditional IRA, you may be eligible to deduct your contributions on your taxes in the same year the contributions were made. In other words, if you contribute $5,000 to a traditional IRA in 2017, you could potentially get a $5,000 tax deduction. The trade-off is that withdrawals from a traditional IRA will be included in your taxable income.
On the other hand, Roth IRA contributions are not tax-deductible, but qualifying withdrawals are 100% tax-free. This is why a Roth IRA is known as an after-tax retirement account – you've already paid taxes on the money you've contributed.
In a nutshell, the biggest decision to make when deciding between a Roth IRA or traditional IRA is whether you'd rather get your tax benefit now or later.
The big advantages of Roth IRAs
There are several reasons you might want to consider a Roth IRA for your retirement savings, such as:
- A Roth IRA lets you lock in your current tax rate since you'll pay tax on your contribution now, but not on your qualified withdrawals. No matter how large your Roth IRA grows, you won't pay a penny to the IRS when you withdraw your money in retirement. This can be an especially good benefit if you're in one of the lower tax brackets.
- Because you've already paid tax on your contributions, you are free to withdraw them (but not any investment profits) at any time, and for any reason. If you don't necessarily want your money tied up until you turn 59 ½, a Roth IRA could be the best choice for you.
- Roth IRAs have no minimum distribution requirements. In contrast, tax-deferred retirement accounts such as traditional IRAs and most 401(k)s generally require retirees to start taking withdrawals by age 70 ½.
- You can contribute to a Roth IRA no matter how old you get, as long as you're earning income.
- Since you can leave your money in a Roth IRA indefinitely, they can be excellent tools for estate planning.
Do you qualify to contribute to a Roth IRA?
Not all Americans qualify to contribute to Roth IRAs. For one thing, you or your spouse need to have earned income to be eligible to contribute. So, if all of your income comes from say, dividends from your investments, you may not be able to contribute to a Roth IRA.
In addition, there is an upper limit on the amount of income that Roth IRA contributors can earn. In order to contribute directly to a Roth IRA, your modified adjusted gross income, or MAGI, must be under certain IRS thresholds, which change annually.
Here's a quick guide that can help you determine your eligibility to make a Roth IRA contribution for the 2017 tax year:
If you don't qualify to make a Roth IRA contribution, there's a way around these income limits. Known as the "backdoor" method of contributing to a Roth IRA, this process basically consists of contributing to a traditional IRA and immediately converting the account to a Roth.
How much can you contribute?
For 2017, the maximum contribution to a Roth IRA is $5,500 per person, with an additional $1,000 catch-up contribution allowed if the account owner is 50 years old or older. If your MAGI is less than the full contribution threshold in the chart, you can contribute up to this full amount, and if your MAGI falls into the partial contribution range, your maximum contribution for 2017 is reduced proportionally.
It's also important to mention that the $5,500 (or $6,500) limit is per person, not per account. This is the maximum an individual can contribute to all of their IRAs for the tax year. In other words, if you have a traditional IRA and Roth IRA, your total contribution between the two accounts cannot exceed the maximum.
How to open a Roth IRA
Opening a Roth IRA is usually quite easy. Compare the fees and features offered by several discount brokerages, and then complete the account-opening process with the brokerage that best meets your needs. Generally, you can open an account by filling out an online form that will take you no more than 10-15 minutes to complete.
You can also open a Roth IRA by converting an existing traditional IRA. You'll most likely have to pay tax on the amount you're converting, but this can still be a good idea in many situations.
How to invest with a Roth IRA
That's up to you! With a Roth IRA, you can invest in virtually any stocks, bonds, ETFs, or mutual funds you want.
Having said that, here are a few words of advice:
For new investors, buying index funds is a smart way to get started. Doing so eliminates the research of choosing individual stocks, and your investment performance won't be too dependent on any single company. In fact, Warren Buffett has said that low-cost index funds are the best way for most Americans to invest.
On the other hand, if you have the time and desire to research and choose individual stocks, we encourage you to do so. Here are some recent suggestions from some of our contributors to help you get started, and here's a more thorough guide to choosing investments for your IRA.
When can you withdraw from your Roth IRA?
The general rule is that in order to withdraw from an IRA, or pretty much any other retirement account, you need to be at least 59 ½ years old, or pay an early withdrawal penalty to the IRS. With Roth IRAs, in order to count as a qualified distribution, the Roth IRA needs to have been open for five years.
However, there are a few early withdrawal exceptions specific to IRAs and Roth IRAs in particular.
I already mentioned that you can withdraw your original Roth IRA contributions without penalty, at any time. So, if you've contributed a total of $25,000 to your Roth IRA over the years, and the account is now worth $60,000, you can withdraw your original $25,000 whenever you'd like. This provision is not subject to the five-year rule.
There's also a first-time home purchase exemption, which allows you to withdraw up to $10,000 to be used toward a first-time home purchase for you or a relative. Additionally, you are allowed to withdraw any amount penalty-free to pay for qualified higher education expenses. For this reason, Roth IRAs are often used as college-savings vehicles.
Other options to save for retirement
The logical alternative to a Roth IRA is a traditional IRA. Depending on your tax situation and retirement goals, a traditional IRA could certainly be a smart choice for some people.
In addition, if you're self-employed, there are several other retirement savings options, all of which have higher maximum contribution limits than Roth IRAs. These include plans such as the SIMPLE IRA, SEP-IRA, and Solo 401(k).
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