Everything You Need to Know About Roth IRAs

Saving money for a car, a vacation or a shopping trip can be hard enough. But saving for 50 years down the road? That’s a challenge. It’s also very necessary.

On top of rising health care costs and lifespans, companies have bid farewell to pensions. That means most people won't have any guaranteed retirement income except for Social Security, which only replaces about 40% of the average retiree's prior wages. So it's up to you to make up the difference with savings.

There are many types of investment accounts to incorporate into your retirement plan, but one that can provide big benefits especially for young people is the Roth IRA.

The key factor when deciding if a Roth IRA is right for you is what your income taxes are now versus what you think they’re going to be in the future, says Kelly Welch, certified financial planner and wealth advisor at Girard in King of Prussia, Penn.

“If you use it correctly, you could be 70 years old and pulling out money tax-free,” Welch says.

What is a Roth IRA?

A Roth IRA is a type of individual retirement account (IRA). Like the name suggests, an IRA is opened by a person on their own, not with their employer like a 401(k). You can open one yourself via a brokerage company like Fidelity or Charles Schwab.

So what makes a Roth IRA different from a traditional IRA? Its tax treatment. With traditional IRAs, you contribute pre-tax dollars — meaning those contributions are tax deductible in the year when you make them and then fully taxable when you withdraw the money in retirement. It’s the opposite with a Roth IRA, and there are benefits to paying taxes upfront.

Benefits: withdrawing money tax-free and more

Contributing after-tax dollars now in exchange for withdrawing money tax-free in retirement is a good move for people who think that their future taxes will be higher than they are now. This could be because your income is higher, pushing you into a higher federal income tax bracket, and/or because the government raised the brackets themselves, a move many experts think will be needed to help the country generate more revenue to repay its growing debt.

Another benefit to the Roth is that you can withdraw any money you contribute at any time, tax free, since you’ve already paid Uncle Sam. When you withdraw money from a traditional IRA, you’ll be taxed on every penny no matter when you take it out. You'll also face a 10% penalty for early withdrawals before age 59 ½. In this way, Roths make it easier to access your money if you face a hardship like job loss or need the cash for an emergency.

What's more, traditional IRAs and 401(k) have required minimum distributions (RMDs), meaning you need to start making withdrawals from your account once you turn 72 years old — regardless of whether you need that money to live on — and pay income taxes on it, or face a steep penalty. With Roth IRAs, there are no RMDs, so your money can keep growing if you don't need it.

What are the eligibility requirements?

To contribute to a Roth IRA, you must have what the IRS calls “compensation.” This includes money you earn from working — like wages, salaries and commissions — but also taxable alimony and separate maintenance you might get from a divorce. Dividends, or pension annuity income are not included in that definition and can't be contributed.

You aren’t eligible to contribute to a Roth IRA if you have modified adjusted gross income over a certain threshold, which is $139,000 for single people in 2020 and $206,000 for married couples.

There’s also an annual contribution limit for these types of accounts: $6,000 in 2020, or $7,000 if you’re 50 or older. By contrast, 401(k) retirement accounts (which are provided by employers) have higher contribution limits: $19,500 a year for those under 50, with those 50-plus allowed an extra $6,500 a year in so-called "catch-up" contributions.

While you can withdraw the money you put into your Roth at any time, you need to meet certain requirements to withdraw any returns your contribution has generated in the market. These include being at least age 59 ½, and the account must have been open for at least five years. Non-qualified distributions, or those that don’t meet these requirements, could face income tax and/or a 10% penalty (there are exceptions, like covering some of your medical insurance if you lose your job).

How to open a Roth IRA

There isn’t a timing trick when it comes to opening a Roth IRA. They can be opened at any time, but your contributions for each calendar year have to be made by your tax deadline the following year (usually April 15).

And there are several ways to open this type of retirement account, including with brokers and credit unions. Make sure you do some research: some companies will provide you a long list of investments to select from, while others are more restrictive. They also vary in how much guidance you’ll get — with some financial institutions you might have to make investment decisions on your own, while others provide advice.

“I would lean towards one with better technology capabilities,” Welch says. She recommends looking for ones with an app that makes it easy to view, manage and rebalance your account, and those that have low minimum investment requirements if you're on a tight budget. With the market constantly welcoming new tools and offerings, they’re now easy to come by.

You can contribute to your Roth IRA via cash or check, contributions from your spouse, rollovers or transfers (from one eligible account to another). The account can hold a variety of investments, including individual stocks, bonds and mutual funds.

Converting your traditional IRA to a Roth IRA

A Roth conversion is when you convert your traditional IRA into a Roth IRA. When making a Roth IRA conversion, you pay income tax on the amount converted, but it can still be a good option for someone young, who will likely make more in the future. That way, you get your tax obligations out of the way when your tax rate is lower. The conversion was a popular move earlier this year, when the coronavirus made the stock market plummet and many people lost their jobs, pushing them into lower tax brackets.

If you choose this route, remember you don't have to convert your entire IRA at once. If converting the entire account will raise you into a higher tax bracket, it might make sense to just shift a portion.

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