What is a Roth IRA?

What is a Roth IRA?

There are numerous options for saving money for your retirement, from stashing bundles of bills under the mattress to a carefully curated portfolio of investments. Most folks fall somewhere in between these two extremes, however, and put money steadily into a 401(k) account — a company-sponsored retirement account — or an IRA, an individual retirement account.

There are two types of IRAs, each with distinct advantages and drawbacks. Today we’re focusing on the Roth IRA. What distinguishes it from its traditional counterpart? Who can take advantage of a Roth IRA? What benefits does it offer, and how is it different from other approaches to retirement savings? Read on to learn the answers to these questions and many more.

First Things First: What Is an IRA and Why Would I Want One?

As you may already be aware, IRA is an acronym that stands for “individual retirement account.” This is in contrast to the typical 401(k) plan, which a company facilitates (and often pays into) for its employees. In the simplest terms, an IRA is a way to save money and to invest money for the long term. It confers tax advantages as well.

The purpose of all retirement savings accounts is to encourage younger people to begin saving for their golden years. As long as you have earned income, you can open an IRA and start funneling money to it.

Where Would I Go to Get an IRA?

IRAs are offered by banks, investment companies, personal brokers, or online brokerages.

Are There Different Types of IRAs?

Yes, there are, but the most common are the traditional IRA and the Roth IRA. There’s one major difference between these two main types, and it has to do with what is taxed, and when. (We’ll get into the details later.) There are also SIMPLE IRAs and SEP IRAs, both of which involve employers. However, these individual retirement accounts are much less common than the traditional and Roth versions.

Okay, So What’s a Roth IRA?

Roth IRAs are relative newbies on the financial scene. Established in 1997, this type of IRA is named after former Delaware senator William Roth. Contributions to this account are not tax-deductible because taxes must be paid before the funds are invested in the IRA. After that, the money is allowed to compound tax-free; down the line, when it’s time to cash in, withdrawals from a Roth IRA will also be tax-free.

That said, the Roth IRA does require that the investor meet certain criteria.

What Are the Criteria I Have to Meet to Open a Roth IRA?

Perhaps the most important factor in deciding whether a Roth IRA is right for your personal circumstance is how much money you make. There’s an income limit associated with this type of account, and if your earnings exceed that limit, the IRS has already made the decision for you.

The limit for income earned in 2021 is $140,000 for single people and $208,000 for married couples who choose to file jointly. These limits will be increasing to $144,000 and $214,000, respectively, for 2022. Note that in this case, “income” refers to modified adjusted gross income (MAGI).

Roth IRAs come with no age restrictions.

How Much Money Can I Contribute?

In addition to the income limits, Roth IRAs have a contribution limit. For 2021 and 2022, that limit is $6,000 for someone who is single, head of household, or married filing separately. The maximum amount you can put into a Roth IRA jumps to $7,000 once the investor is age 50 or over.

However, this contribution amount can also differ depending on your income. If your MAGI is under the $144,000 limit but over $125,000 (2021) or $129,000 (2022), you will still be able to fund your Roth IRA account, but the exact amount will be slightly lower than what it would be if you earned less than $125,000 or $129,000. There are a few variables at play here; to see where you fall, take a look at this chart.

What Are the Benefits of a Roth IRA?

Time to learn about what makes a Roth IRA such an appealing investment!

1. Tax-free growth and withdrawals

The biggest and best benefit of Roth IRAs is that both growth and withdrawals are tax-free. In a traditional IRA, you’ll invest pre-tax dollars and can therefore avoid paying tax on contributions. You can also take tax deductions right away. However, you will be taxed when you withdraw the funds.

The Roth IRA model is completely different. You pay taxes upfront rather than upon withdrawal, but you can’t claim the investments on your tax return. When you reach age 59 and a half, however, you won’t have to worry about paying taxes on the contributions you’ve made over the years.

2. A great way to transfer wealth

Putting your money into a Roth IRA reaps benefits for you and your heirs. It’s possible for your children, spouse, or other beneficiaries to continue growing the account tax-free. When it comes time to take distributions, they will also inherit the tax-free advantage of this investment account.

One word of caution: There are a few rules that you and your beneficiaries need to understand. Make sure you do your due diligence if you’re thinking about transferring your wealth in this fashion.

3. More freedom when it comes to withdrawing contributions

Many other retirement accounts will penalize investors for withdrawing their own money early, but not so for Roth IRAs. It’s not advisable to withdraw large sums or even small but frequent sums; an IRA shouldn’t be treated like a checking account. However, if an emergency strikes, you won’t incur penalties by choosing to withdraw contributions.

4. No age limit for a Roth IRA

This benefit will be a boon to people who are tired of being told they’re too young or too old to do what they want to. There is no longer an age requirement, either on the high or the low end, for opening up a Roth IRA. All you need is to have what the IRS calls “taxable compensation” (which includes wages, salaries, commissions, self-employment income, and alimony) instead of money from investments.

Additionally, a non-working spouse can contribute to a spousal Roth IRA. This helps a married couple to reap even more benefits if one of the partners is unemployed or a stay-at-home parent.

5. Roth IRAs don’t have required distributions

The other major retirement savings accounts all come with an RMD, or required minimum distribution. In layperson’s terms, this means you are obliged to take a certain amount of money from your account at least once a year. Why would it be a bad thing to have to take this distribution? In this case, it’s because that particular chunk of money will stop compounding, and you’ll have to pay taxes on it. A Roth IRA is the only option if you want to leave your money in place, earning interest and remaining tax-free.

Wrapping Up

Roth IRAs aren’t the perfect choice for everyone — but then again, no investment really is. However, this approach to retirement savings can be an excellent option for those who fit the criteria and anticipate growing into a higher tax bracket by the time they retire. Roth IRAs’ after-tax contributions, lack of RMDs, and more lenient, penalty-free withdrawal policies are advantages that can help you grow a tidy little nest egg for yourself, your spouse, and even your beneficiaries.

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