A Roth IRA Is a tax-advantaged way to save for retirement that most working people can use
You're likely familiar with the concept of individual retirement accounts, or IRAs, and have maybe even nodded knowingly when someone close to you talked about their Roth. But what exactly is a Roth IRA, and how does it differ from other retirement accounts like traditional IRAs or a 401(k)? And even more importantly, should you get one?
The short answer is yes — assuming you're within the bracket that allows you to contribute. But for the long answer, read on, because here's everything you need to know about Roth IRAs.
What Is a Roth IRA?
To use the technical jargon, a Roth IRA is an individual retirement account that's exempt from capital gains taxes. They've been a part of tax law since 1997's Taxpayer Relief Act, and are named for Delaware Senator William V. Roth, Jr., who sponsored the legislation that led to their creation.
What Makes It Different From a Traditional IRA?
Let's start from the top. (And untangle some of that jargon.) If you work for a living, you'll want to put a portion of your wages aside on a regular basis so that you have funds to draw on when you're no longer bringing in a regular paycheck in retirement.
In order to encourage this type of long-term planning, many financial institutions offer tax-advantaged accounts where you can sock your money away long-term. It's important to note that paying into these accounts doesn't remove your tax obligation altogether; at the end of the day, every dollar that you put into an IRA is going to be taxed. But exactly when you pay that tax is what differentiates the types of accounts.
A traditional IRA is what's called "tax-deferred," meaning you pay taxes on the funds when you take them out rather than when you put them in. Contributing to those accounts earns you a credit in the short term — come Tax Day, you can deduct the amount you paid into your IRA from your tax bill. It's when you go to withdraw from that account that it will come time to pay the piper — those withdrawals will be taxed like regular income at whatever tax bracket you're in.
This aspect is particularly important to note, because if all goes well in your career, your retirement-age income will be much higher than your current income. Meaning you'll likely be paying taxes on your retirement funds at an inflated rate, having been boosted into a higher tax bracket.
But for the Roth IRA, things are the other way around. There's no tax incentive in the short term; your entire income will be taxed as usual, no matter how much you pay into your Roth. (Up to the limit, of course; more on that later.)
With the Roth, it's in the long term that you see the benefits. Assuming you don't withdraw the money early, the money will typically be distributed tax-free in retirement, even if interest and investments mean the original sum has grown by leaps and bounds — and even if you're in a tax bracket well above where you were for those original contributions.
You can withdraw your contributions from a Roth IRA without penalty before age 59 1/2, but not your earnings; that's not the case with a traditional IRA — you'll pay a penalty for early distributions.
If you think you may be in a lower tax bracket in retirement, a traditional IRA may be the way to go.
Who Is Eligible for a Roth IRA?
Because of all that potential for tax-free growth, the Internal Revenue Service has placed some restrictions, both on who can contribute to a Roth IRA, and how much.
The first requirement is that you have "taxable compensation," meaning that your source of income for the year is a salary or wages rather than passive income like rental properties, interest, or a pension.
The second is that your modified adjusted gross income, or MAGI, fits within certain limits. (It's basically your adjusted gross income with some deductions added back in.) For 2020, those married and filing jointly will need a MAGI below $196,000 in order to make a full contribution, or under $206,000 to qualify for a partial contribution. For single folks, heads of household, or those who are married and filing separately, the limits are $124,000 and $139,000, respectively.
These limits make the Roth an especially appealing option for younger investors.
How Much Can I Contribute to My Roth IRA?
For those 49 and under who meet the above requirements, the most you can contribute to your Roth for the years 2020 and 2021 is $6,000. Those aged 50 and older, meanwhile, see the cap raised to $7,000, with the hope that the increase will help those closer to retirement age catch up on savings.
Make sure you look up the cap when you're filing, because it tends to go up by around $500 every couple years, and when it comes to tax-free growth, every dollar counts.
When Can I Withdraw My Money?
You can withdraw your contributions from your Roth IRA at any time. But with a few exceptions for emergencies, only qualified distributions of contributions and earnings made after age 59 1/2 go untaxed.
If you make an early withdrawal, you might have to pay an additional 10% tax — which you'll remember is on top of the taxes you already paid on this income.
How Do I Invest?
These days, the opportunities to invest in a Roth IRA are practically endless, with many financial institutions like banks and brokerages offering their own accounts that you can sign up for online or at brick-and-mortar locations.
Some firms will require annual maintenance fees or initial deposits above a certain dollar amount, so make sure you shop around for the right one for you. But across the board, they'll provide a wide variety of investment options that include stocks, bonds, mutual funds, exchange-traded funds (ETFs) and certificates of deposit (CDs), with your portfolio entirely within your own control.
It can feel intimidating at first, but luckily, there's plenty of great advice out there to help you get started. A good rule of thumb is to make your investment decisions based on two main factors: The amount of time left until retirement, and how much risk you're willing to take on, which will determine your ratio of stocks to bonds.
Choose wisely and invest early, and your Roth IRA can grow steadily for decades, setting you up for a comfortable, happy, and tax-free retirement.