What is a Roth IRA? How to take advantage of after-tax benefits when saving for retirement
Roth IRAis a retirement accountyou can use to invest in stocks, bonds, and other securities.
- You fund Roth IRAs with post-tax dollars so withdrawals are not subject to income tax once you hit retirement age.
- Roth IRAs are most advantageous for people who expect to pay higher taxes in the future than they are right now.
When saving for retirement, you have many options to choose from. There are 401(k)s, 403(b)s, thrift savings plans and several types of IRAs.
Though any of these vehicles can help you grow your wealth and live a comfortable life in retirement, Roth IRAs are the only ones you can draw from tax-free. This can be particularly beneficial when you're older, on a limited income and potentially facing higher income taxes.
Here's what you need to know about these valuable types of retirement accounts.
What is a Roth IRA?
A Roth IRA is a type of individual retirement account that you fund with after-tax income - or money you've already paid income taxes on.
This means you won't pay taxes when withdrawing from your account later on, even if your tax bracket changes. Because of this, Roth IRAs can be advantageous for those who are in the early stages of their careers, as it allows more time for the investments to grow (and you may be in a lower tax bracket when you're just starting out).
"Roth IRAs are a type of individual retirement account in which you pay taxes now rather than later," says Hannah Whatley, an advisor and CFP at Rather & Kittrell Wealth Management. "The beauty of this is that your earnings are growing tax-free. This is often especially advantageous for young savers, who may not be in their peak earning years and also have plenty of time for the tax-free growth to compound."
Anyone can open a Roth IRA - so long as they have earned income, which is one of the few ways to fund this type of account. You'll just choose a brokerage, and a representative will help you open the account in your name. You can then begin funding your account, choosing investments, and building toward retirement.
Understanding how a Roth IRA works
Roth IRAs are funded with post-tax dollars. Once an account is funded, you can use the cash to invest in stocks, bonds, ETFs, mutual funds and other securities. As these grow in value, so does your Roth IRA balance, which you can then withdraw from in retirement.
"I get asked frequently, 'What is the return of a Roth IRA?'" says Sean Burke, vice president and director of institutional money management at Stuart Estate Planning Wealth Advisors. "The Roth IRA is simply a shell to protect you from taxes. Within that shell, you can invest in many different securities. The return of your Roth IRA depends on how the underlying investments perform."
There are several ways to fund a Roth IRA. These include:
- Direct contributions: You can contribute using a check or electronic funds transfer from your bank account.
- Spousal contributions: If you file a joint tax return and make less than your spouse, you can contribute to a Roth IRA in their name (and vice versa).
- Rollovers: Funds from 401(k)s and other employer-sponsored retirement plans can be rolled over into a Roth IRA account.
- Conversions: You can also convert an entire traditional IRA account into a Roth IRA. This is often referred to as a "backdoor" Roth IRA and can help you avoid contribution limits.
Keep in mind that with rollovers and conversions, you will need to pay income taxes on the amount of money you move or convert.
Roth IRA withdrawal rules
Since Roth IRAs are technically retirement accounts, you're not supposed to withdraw funds until at least age 59.5. If you withdraw money before this point, you'll pay a 10% penalty on the total amount withdrawn.
Unlike traditional IRAs, there are no required monthly distributions (RMDs), so even once you reach age 72 - when you'd need to start withdrawing on a regular IRA, you can leave the funds to keep growing or even contribute more if you'd like.
"You can invest in a Roth IRA beyond the RMD age of 72 and take advantage of tax-deferred growth," says Matt Rogers, director of financial planning at eMoney Advisor. "This is a useful tool to control your taxable income in retirement and supplement it with tax-free Roth IRA distributions - a move that is quite tactical."
Annual Roth IRA contribution limits
There are limits to how much you can contribute to a Roth IRA. For one, you can only contribute up to $6,000 per year if you're 49 or younger. If you're 50 or older, the limit is $7,000.
Contributions are also limited by household income. Here are how those limits breakdown:
|Tax filing status
|Modified Adjusted Gross Income
|Single, head of household or married filing separately and you do not live with your spouse
|Less than $125,000
|Up to $6,000 to $7,000 per, depending on age
|Between $125,000 and $140,000
|$140,000 or more
|Married filing separately and you live with your spouse
|Less than $10,000
|$10,000 or more
|Married filing jointly or widow/widower
|Less than $198,000
|Up to $6,000 to $7,000 per, depending on age
|Between $198,000 and $208,000
|$208,000 or more
Quick tip: Backdoor Roth IRAs can help you contribute beyond the above limits. You'll contribute the funds to a traditional IRA and then convert the account into a Roth IRA. Speak to a financial advisor if you're considering using this strategy, as it can get complicated.
Roth IRA vs. 401(k)
A 401(k) is another type of common retirement account, though these function very differently than Roth IRAs. One is opened by individuals, while the other is offered by employers only.
"A 401(k) is an employer-sponsored plan only offered through employers as a workplace benefit," Rogers says. "A Roth IRA can be used by anyone who has earned income regardless of whether their employer offers a 401(k) or not."
The two accounts also come with different tax treatments, which is critical to think about when saving for retirement. With 401(k)s, you fund the account using pre-tax dollars and then pay taxes on your withdrawals later on. Roth IRAs are the opposite.
Here's a full breakdown of how the two types of accounts differ:
|Opened by an individualFunded with post-tax fundsWithdrawals are not subject to income taxAccount-holders can choose which investments they'd like to purchase
|Offered only by employers as a benefit to workersFunded with pre-tax fundsWithdrawals are subject to income taxOften come with employer matching, meaning the company will contribute funds as wellEmployer chooses all investments
Quick tip: A Roth IRA is a better option if you're in a lower tax bracket now but expect to be in a higher one later on. If you're currently in a high tax bracket, a 401(k) or traditional IRA may be a better choice instead.
The financial takeaway
Roth IRAs can be a smart way to save up for retirement and avoid high tax bills later on in life. Keep in mind, though, they can also be used in tandem with other retirement accounts, including 401(k) and traditional IRAs.
If you're considering opening a Roth IRA, talk to a financial advisor first. They can help you devise the best strategy to maximize your wealth and minimize your tax burden.9 ways to withdraw money early from your IRA - without paying a penaltyUnderstanding Roth IRA withdrawal rules helps you avoid taking money too soon, triggering taxes and penaltiesBorrowing from your 401(k) plan can be a fast, advantageous way to meet serious financial needs - here's everything you need to know about 401(k) loansWhat is a rollover IRA? How to transfer funds from your 401(k) to an IRA and avoid taxes
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