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What is a Roth IRA?

A Roth IRA is an individual retirement account, established by William Roth in 1997, that allows you to pay taxes up front in order to have tax free withdrawals upon retirement. This type of retirement account is ideal for those who are just starting out investing or are beginning their careers in a relatively low tax bracket. 

You can only contribute a set post-tax amount though — based on your age and income level. Within this account, you can buy the mutual funds, individual stocks, index funds, etc. of your liking. With this in mind, who should open a Roth IRA? Why might it make sense for you to start investing in one now?

Who Should Open a Roth IRA?

There are several retirement plans that someone should consider — a plan that is growing in popularity is the Roth IRA. Someone who is in a lower income tax bracket right now than they expect to be when they retire should consider a Roth IRA as soon as possible. All age ranges can contribute, but young people specifically should aim to put as much as they can in a Roth IRA — if possible, try to hit the contribution limit. 

This type of retirement account allows you to pay your taxes up front, and allows you to avoid the taxes on the back end. This is ideal if you make good investments within the Roth IRA and potentially have decades worth of compounding earnings — tax free!

How To Open an IRA

Opening a Roth IRA is a very simple task that should take you only a few minutes to do — you can do so via your employer or an individual brokerage of your choice!

Your Employer

While you may assume that an IRA must be opened by yourself, given that it says “individual” in the name, this is not exactly the case. There is a very good chance that your employer will help you to set up a Roth IRA with a financial institution. 

 Opening an IRA through your employer is rather simple:

  • You establish a Roth IRA through your employers’ benefits website (sometimes they offer a variety of options — 401K, Traditional or Roth IRA, etc.) 
  • For the Roth IRA, you would need to authorize an amount or percentage of your income that would like to be contributed
  • Your employer would deduct that dollar amount or percentage of your income from your payroll and contribute it to the institution 

Opening a Roth IRA with a Broker

Sometimes your employer may not be able to assist in opening a Roth IRA, but don’t worry, with a broker it is incredibly simple. There are many different brokerages that can easily open a Roth IRA for you.

You only need to spend a short amount of time, choose the brokerage of your liking, and open an account and start investing! Some of the most common brokerages that you can use to open a Roth are as follows:

Contributing to a Roth IRA

In order to contribute to your Roth IRA, you can do a couple things based on how you have your account set up: 

  • If you have this set up through your employer: 
    • It will automatically be deducted from your paycheck into your account
  • If you are managing your own account: 
    • You will just need to log in to your account and manually transfer funds over from your bank or credit union. 
    • This can also be set up automatically at each pay period, similar to how your employer handles it — except this is more of a directed approach

It is important to note that you can only contribute to an IRA if you have income — any unearned income (interest or dividends, rental property income, alimony, a pension, etc.) is restricted and cannot be contributed to an IRA.  

Contribution Limits of a Roth IRA

Individual retirement accounts have a limit for contributions, and it varies by the year as well as your age. For an IRA, whether it is Traditional or Roth, there is a maximum combined contribution limit. 

You can contribute as frequently as you would like within a particular year, as long as you do not go over those designated limits. For Roth, however, there are additional stipulations for contributions. You must consider the following: 

  • For 2019 and 2020:
    • The total contributions you can make each year to all of your IRAs (both Roth and Traditional) can’t be more than: $6,000 combined (If you’re age 50 or older you can add $1,000 for catch up — $7,000 total)
  • Contribution Limits for a Roth IRA — Depending upon your MAGI (Modified Adjusted Gross Income):
    • Married filing Jointly: 
      • Up to the limit: Less than $196,000
      • A Reduced Amount: Greater than or equal to $196,000, and less than $206,000 
      • Zero: Greater than $206,000
    • Single Head of Household or Married filing Separately: 
      • Up to the limit: Less than $124,000
      • A Reduced Amount: Greater than or equal to $124,000, and less than $139,000 
      • Zero: Greater than $139,000

Roth IRA and Taxes

With Roth IRAs you pay your taxes up front, which means that all future withdrawals will be tax free. All of your earnings in a Roth IRA grow tax free, so when you reach that retirement age, you will not be taxed upon qualified distributions. 

For comparison, with a Traditional IRA or a 401K for example, the withdrawals are tax deferred. This means that you receive a tax benefit up front, but you pay taxes on all of the earnings on the back end upon withdrawals. 

Roth IRA vs Traditional IRA Age Limits

With recent changes starting in 2020, the age limits for both Roth and Traditional IRAs are essentially the same. For both Traditional and Roth IRA, the following hold true: 

  • No age limit to open a Roth IRA or Traditional IRA
  • There is no age limit to contribute to a Roth IRA or Traditional IRA (starting in 2020)
  • Cannot withdraw from a Roth or Traditional IRA until age 59.5. If you do, there is a 10% penalty, as well as income tax, on any amount withdrawn

The main distinction between Roth and Traditional IRA is that in a Traditional IRA:

  • You must take required minimum distributions by April 1st in the year at which you turn age 72 (starting in 2020). 

Withdrawing From a Roth IRA 

You may need to withdraw from your Roth IRA early, based on certain personal situations. There are several important things to consider if you are thinking about withdrawing from your Roth IRA. Whether you are waiting for retirement age, or considering an early withdrawal — these are the considerations:

  • You can withdraw your contributions tax and penalty free at any point in time — a Roth IRA can serve as an emergency savings fund.
  • Growth on your principal is exempt from taxes. One caveat — if you withdraw prior to age 59.5, there is a 10% penalty and incur income tax on anything withdrawn.
  • If you wait until retirement age (designated as 59.5) you can withdraw your money penalty and tax free how you see fit! 
  • There is no requirement for withdrawal until after the death of the owner of the Roth IRA — the beneficiaries will get distributions upon this event. 

Pros and Cons With A Roth IRA

It is important to weigh the pros and cons with any financial decision that you make. A Roth IRA provides the following benefits, as well as a few limitations. Here are some things to consider with a Roth IRA account:

Pros: 

  • No required minimum distributions (RMD), so you can keep your money safely in this account as long as you are alive
  • At the required qualified age of 59.5 years — Tax free distributions on all earnings on investments
  • There are no taxes on your actual contributions if you need to withdraw early (gains will be taxed however if withdrawn early — as well as a penalty)

Cons:

  • Your Modified Adjustable Gross Income (MAGI) must fall within a particular set range (The range is depending on if you are single vs. married — see above for breakdown)
  • There are no up front tax deductions — all of the contributions are post taxes (essentially out of pocket spending money)