An individual retirement account, or IRA, allows you to save for retirement while gaining tax and investment advantages. A Roth IRA is a specific type of retirement account that offers unique tax benefits.
With a traditional IRA, the money you put into your account before you pay taxes on it, which has several advantages. You have to pay those taxes when you withdraw money down the line. With a Roth IRA, it’s the opposite: you pay tax on the money when you put it in the account, but both your contributions and any investment earnings are tax-free when you use them. That feature also enables several other advantages that make a Roth IRA worth considering if you’re looking for a way to save for retirement.
How Does a Roth IRA Work?
Like all IRAs, a Roth IRA is an individual account, not an employer-sponsored account like a 401(k). You can open a Roth IRA with any bank or brokerage that provides IRAs.
You can contribute to your IRA at any time. There is an annual limit to IRA contributions in any given year, and that limit can change from year to year. In 2020 the limit is $6000/year if you are under age 50, $7000/year if you are over 50. The money you contribute to your Roth IRA is post-tax. It is taxed as regular income in the year you make the contribution.
Roth IRAs are designed to provide tax-advantaged retirement saving vehicles for middle-class people. If you are above a specified income limit your contributions will be limited, and if your income is too high you cannot contribute at all. If you are above the income limit you can consider opening a backdoor Roth IRA.
These are the Roth IRA Income limits in 2020.
|Filing Status||2020 Income||Maximum Annual Contribution|
|Single, Head of Household, or Married, filing separately and did not live together at any point during the year||Below $124,000||Full allowable contribution|
|$124,000 to $139,000||Reduced Contribution|
|$139,000 or Above||No Contribution|
|Married filing jointly or qualified widow(er)||Below $196,000||Full allowable contribution|
|$196,000 to $206,000||Reduced Contribution|
|$206,000 or Above||No Contribution|
|Married filing separately, lived together at any point during the year.||Below $10,000||Reduced Contribution|
|$10,000 or Above||Reduced Contribution|
These amounts are based on Modified Adjusted Gross Income or MAGI, which is the Adjusted Gross Income reported on your tax return with any interest income that is tax-exempt and some deductions added.
If you open a Roth IRA with a brokerage firm you will be able to invest your funds in a variety of mutual funds or other investment products. If your Roth IRA provider is a bank your investment options may be limited.
You can withdraw your contributions from a Roth IRA without penalty at any time. You have already paid tax on them, so the IRS doesn’t care what you do with them.
If you are over age 59 ½ and have held your Roth IRA for over 5 years you can withdraw your investment earnings tax-free. If you don’t meet those qualifications any earnings you withdraw will be taxed as income.
Advantages of a Roth IRA
You have already paid taxes on the money in a Roth IRA, so the government places fewer restrictions on it than it does on accounts that have not yet been taxed. That produces some distinct advantages for Roth IRAs:
- You can contribute to both a Roth IRA and a 401(k). Other forms of IRA may not allow contributions if you have a 401(k).
- Longer contribution period. You can make contributions to a Roth IRA up to the tax deadline for the year in which you report them. You can make contributions to a Roth IRA up to July 15, 2020, and still report them as 2019 contributions.
- There is no age limit. You can open a Roth IRA at any age, as long as you have earned income.
- You can withdraw contributions to a Roth IRA at any time without paying tax. If you withdraw investment earnings before age 59 ½ or when your account is less than 5 years old, you will pay income tax on the earnings.
- No required minimum distributions. If you have a traditional IRA you must take a minimum annual distribution from your IRA starting at age 72. If you have a Roth IRA you can leave it alone for as long as you like, and even pass it on to your heirs.
These advantages are strong reasons to select a Roth IRA.
Who Should Consider a Roth IRA?
Roth IRAs are particularly appropriate to people in certain circumstances:
- Younger workers in relatively low tax brackets. If you’re in a low tax bracket you can set money aside at a low tax rate and then draw it tax-free when your tax rate is higher.
- Anyone who expects to be in a higher tax bracket after retirement. You might expect your post-retirement income to be lower, but you may have fewer deductions and additional income from social security and investments. Many retirees find themselves in a higher tax bracket.
- Anyone who wants reserve retirement funds. Because there are no required minimum disbursements, you can hold a Roth IRA until later in your retirement and even pass it on to your heirs if it’s not needed.
- Anyone who wants the option of tax-free funds after retirement. Tax-free money can be useful in several ways. For example, a disbursement from a Roth IRA can get you additional money without pushing you into a higher tax bracket.
Remember that you can open both a Roth and a traditional IRA, as long as your combined contributions don’t exceed the annual limit. Consider funding a Roth IRA earlier in your career when you’re in a lower tax bracket and a traditional IRA later in your career when you move into higher tax brackets and your income may exceed the Roth contribution limits.
You can also fund both a Roth IRA and a 401(k) to diversify your retirement funds.
A Roth IRA is a valuable tool for retirement savings, offering advantages that few other types of retirement accounts can match. It’s an option worth considering, either as a stand-alone retirement savings account or to diversify your retirement financing options.