A Roth IRA is a unique retirement savings vehicle that has the stamp of approval from Uncle Sam, offering retirement withdrawals tax-free -- after paying taxable contributions into your Roth IRA.
Roth IRA's have proven to be a great long-term savings vehicle, especially for younger workers, who are typically in a low tax bracket today, but will be in a higher tax bracket when they're in their 60's and 70's, and at retirement age. Retirement-aged Americans who wish to bequeath assets to their heirs can also benefit by giving Roth IRA proceeds tax-free.
Roth IRA's are gaining steam in the American retirement planning landscape. According to Investment Company Institute statistics, 24.9 million American households had a Roth IRA in 2017.
There's little doubt that retirement-minded Americans are starting to see, and act on, the advantages of a Roth IRA plan.
What is a Roth IRA?
Roth IRA's are in the same individual retirement account family as traditional IRA's, but with key differences.
By and large, Roth IRA's allow account holders to contribute after-tax dollars to their retirement savings, then withdraw account dollars out tax-free once they reach retirement. There are no age restrictions when contributing to a Roth IRA, and you aren't required to take out any required minimum distributions from your Roth IRA account.
Roth IRA's are a great deal if you believe you'll rise to a higher tax bracket down the road - you'll benefit by taking tax-free benefits from your retirement savings account in that scenario. On the downside, you may be subject to income limitations when opening a Roth IRA.
Getting a Roth IRA up and running is easy. All you have to do is demonstrate you have earned income from a job - either from an employer or if you're self-employed. That makes you eligible for opening a Roth IRA account.
Traditional IRA vs. Roth IRA
There are several key similarities and differences between traditional IRA's and Roth IRA's.
Similarities between the traditional IRA and Roth IRA:
- Contribution limits: For 2018, contributions for traditional IRA's and Roth IRA's are the same - $5,500 (age 49 and under) and $6,500 if you're age 50 or older
- Contribution deadline: Deadlines are the same for both IRA's which is usually on tax deadline day - on or around April 15 each year.
- Minimum investments: There is no minimum investment to open a Roth IRA or a traditional IRA.
- Fees:Investment management fees are usually the same when using Roth IRA's or traditional IRA's.
Differences between traditional IRA and Roth IRA:
- Roth IRA's contributions are never deductible, but qualified withdrawals from a Roth IRA are nontaxable. That's different with Roth IRA's, where earnings are non-taxable when withdrawn, provided you meet the holding requirements.
- Also unlike traditional IRAs, the IRS does not require you to take a distribution from a Roth IRA when you reach age 70 1/2.
- With Roth IRA's, your income does impact your contribution limits. Traditional IRA's have no income limits for contributions.
Benefits of a Roth IRA Plan
Besides the advantage of tax-free distributions in retirement, Roth IRA plans offer retirement savers myriad benefits, including:
Roth IRA's are flexible
With a Roth IRA, you can take your assets out of your plan whenever you like without fear of any taxes or penalties. You can also use your Roth IRA account to pay for higher education costs for yourself or a family member, or put $10,000 down on a new home, and not pay any IRS penalties. You will, however, be subject to regular income taxes on the withdrawal amount.
Roth IRA's help with tax diversification
- Having a Roth IRA also offers retirement savers some much-needed tax diversification. Here's why. Retirees often have different sources of income in their Golden Years, including Social Security, investment income, and retirement plan distributions (and maybe income from a part-time job.) Those multiple sources of income can push retirees into a higher tax bracket, and dip into their annual income. By withdrawing cash from your Roth IRA, you can access income, and still reduce your overall tax liability.
No mandatory minimum distributions
Upon hitting age 70½, by law you'll have to begin withdrawing cash from traditional 401k's and from traditional IRA's - whether you need the income or not. That's not the case with Roth IRA plans, where there aren't required minimum distributions, at any age.
You can still save money in retirement
As long as you remain within income limits, you can still save money for retirement after you're past your retirement age, using your Roth IRA account. That's not the case with traditional IRA's, where you can't make tax-advantaged retirement contributions once you retire.
Roth IRAs are not without some restrictions, however.
As with traditional IRAs, distributions of earnings are taxable and subject to a 10 percent penalty if taken out prematurely. With a Roth, you must leave your money in for five years. If you're eligible for both a deductible traditional IRA and a Roth IRA, your choice can be a difficult one. You'll need to balance your need for current deductions with your desire for tax-free retirement income
How to Invest in a Roth IRA
Your next step in the Roth IRA process is opening an account. Ideally, plan participants should work with a reputable investment management firm, but you can usually handle the process yourself.
Basically, there are three key steps in opening a Roth 401k Plan:
Step 1: Figure out your contribution amount
The Internal Revenue Service has established contribution limits of $5,500 annually for Roth IRA plan participants. However, Americans over the age of 50 are allowed a "catch up" hike in contributions, to $6,500. Annual deadlines for opening a Roth IRA account and making contributions is April 15 of the following tax year.
Step 2: Choose your investments
Now that you know your eligibility standing and your contribution limits and dates, it's time to start selecting investments to stock your Roth IRA. When making your investment selections, carefully review your long-term investment goals, and assess your own investment risk levels. Reviewing your retirement goals and needs can help choose the investment best suited for your own unique needs. By and large, there is a wealth of investment categories to choose from for your Roth IRA, including stocks, bonds, certificates of deposit (CDs), mutual funds, exchange-traded funds (ETFs), or a "single-fund" option, where the asset allocation is selected for plan participants. Additionally, real estate, commodities, and even foreign stocks and funds are eligible for inclusion in a Roth IRA.
Step 3: Choose a Roth IRA investment manager
There is no shortage of potential Roth IRA providers, including banks, mutual fund companies, brokerage firms, insurance companies, and online-only investment firms. When choosing a firm, ask about key issues that otherwise may be overlooked, like account management fees and demonstrated portfolio results.
Step 4: Organize your documentation
After you find an investment manager, make sure all of your ducks are in a row and that you have all of the necessary paperwork, which includes:
- Your driver's license or another form of photo identification.
- Your Social Security number.
- Your bank's routing number and your checking or savings account number.
- Your employer's name and address, if you're opening an account at work.
- The name, address, and Social Security number of your plan beneficiary.