Employer-sponsored retirement program—401(k) plans or a 503b for nonprofit employers—are great, but if you’re self-employed or your employer doesn’t offer a retirement plan, an individual retirement account (IRA) is the way to go. IRAs are also a great choice if you want to supplement your employee-sponsored retirement savings, or if you just want more investment options.
The Roth IRA is one of two types of IRAs (the other is known as the traditional IRA) established by the U.S. Congress, to encourage Americans to save for retirement. Roth IRAs also allow greater flexibility in withdrawing funds than other retirement plans, and their unique income-tax advantages can make them especially attractive to young people just beginning their careers.
Here’s an overview of the Roth IRA, a summary of how it’s similar to and different from traditional IRAs and employer-sponsored retirement plans, and some guidelines on getting the most from a Roth IRA if you choose to open one.
|Comparison of IRA Plans|
|Roth IRA||Conventional IRA|
|Maximum annual contribution (2017)||$5,500 ($6,500 if over 50)||$5,500 ($6,500 if over 50)|
|Maximum income allowance||$133,000 for individuals filing singly; $186,000 for couples filing jointly*||None|
|Withdrawal of contributions subject to income tax?||No, as long as fund has been kept five years||Yes|
|Withdrawal of fund earnings subject to income tax?||Maybe, if withdrawals are made before age 59½.||Yes|
|Early withdrawal penalty?||Some withdrawals of fund earnings made before age 59½ are subject to 10% penalty.||10% penalty on some withdrawals made before age 59½.|
|Age restriction on contributions||None||70½|
|Age when distributions become mandatory||None||70½|
Both Roth IRAs and traditional IRAs offer significant income-tax benefits, but the way the IRS treats contributions to each is probably the biggest difference between the two. When comparing them, it may be helpful to think of the mechanic’s catchphrase from an old car-repair commercial: “You can pay me now, or you can pay me later.”
Roth IRA savings are post-tax contributions: You pay taxes on them now. You can’t deduct contributions from your tax return, but when you withdraw the funds the proceeds won’t be taxable as income—as long as long as you’ve had your Roth IRA for at least five years. If the amount in the fund has grown, that can mean major income-tax savings.
With traditional IRAs and employee-sponsored retirement plans, funds you place in the account are tax-deferred, meaning you pay your taxes later. That means you can deduct the amount you save from the income you report to your state and the IRS—with the understanding that you’ll pay taxes on the money (including any investment income) when you withdraw it from the fund.
Roth IRAs can be especially beneficial to people just starting in their careers, when their incomes—and income-tax rates—are relatively low.
By contrast, traditional IRAs are advantageous to high earners in high tax brackets; sinking their money into a tax-deferred fund lets them avoid paying taxes at a peak rate, and instead pay taxes money in retirement, when their income and tax rate are usually lower.
Rules of the Game
With both Roth IRAs and traditional IRAs, you choose a bank, credit union or brokerage to host the account, select the type of investments you want (stocks, mutual funds, exchange-traded funds, etc.) and then set up regular contributions. Ideally, your investment grows steadily until you’re ready to retire, and you can start withdrawing money for use in retirement.
Before you begin, it’s important to know the rules that govern the process. Be aware that these rules are subject to change, but these figures are accurate as of October 2017:
- Eligibility: There are income limitations on who can participate in a Roth IRA, and they’re based on a rather arcane figure known as modified adjusted gross income (MAGI). For most people, this is very close to the adjusted gross income reported on federal income tax returns. You are eligible to participate in a Roth IRA or a traditional IRA if you are single with a MAGI of $118,000 or less, or married and filing jointly with a combined MAGI of $186,000. Individuals with MAGIs as high as $133,000 and couples with joint MAGIs as high as $196,000 can participate in Roth IRAs, but with lower maximum contributions.
- Maximum contributions: You can put up to $5,500 ($6,500 if you’re 50 or older) into a Roth or traditional IRA, or a combination of both. That’s in addition to the maximum contribution of $18,000 you can make to any employer-sponsored retirement plan you may have. The amount you contribute to the Roth IRA in any given year cannot exceed the amount of “earned income” (wages, tips, and other compensation) you report on your tax return for that year.
- Roth IRA Rollovers: If you have an existing 401(k) or 503b plan from an old employer, you can convert it to a Roth IRA via a two-step process: Convert the 401(k) to a traditional IRA, and then convert that account into a Roth IRA. Taxes must be paid on the 401(k) funds if you do this, so determining whether it makes sense to do a Roth IRA conversion, or rollover is complicated. The institution where you open your Roth IRA can assist with the process, but it might be wise to consult with an accountant or tax advisor before choosing this option.
- IRAs for children: Many parents also open Roth IRAs for their children; there is no minimum eligibility age, and investments begun in childhood can grow tremendously over a lifetime. To qualify, the child must have earned income. Allowances don’t count, but proceeds from babysitting, lawn mowing and the like do, as do wages and tips from part-time jobs. The amount placed in a child’s Roth IRA cannot exceed his or her earned income in a given year, and the child may have to file a tax return each year Roth IRA contributions are made on their behalf.
- Taking money out of Roth IRAs: Roth IRAs are more flexible than other retirement plans about how and when you can withdraw funds—or leave them alone, as you prefer. Once you’ve had a Roth IRA for five years, you can withdraw as much as you’ve contributed to it anytime, tax-free and without penalty. If you withdraw any of the earnings you’ve received on those contributions, before age 59½, you may be subject to taxes on the sum, and pay a 10% penalty on those.
You can even make withdrawals before the five-year mark under certain conditions including certain medical expenses, college payments, and disability. That’s a major difference from traditional IRAs, which cannot be drawn down until you are 59½ without a penalty and tax consequences.
Traditional IRAs also require you to stop making contributions and begin making withdrawals by age 70½, but you can continue adding to a Roth IRA indefinitely as long as you have earnings (from a part-time retirement job, for example). You never have to make withdrawals from a Roth IRA unless you choose to; they can even be passed on to your heirs.
Setting up a Roth IRA
Roth IRAs are widely available from banks, credit unions, and brokerage houses. Investment options and fees vary widely from plan to plan, so you should study the options carefully and ask lots of questions to determine which plan is best for you.
Go into the discussion with an idea of the amount from each paycheck that you want to contribute to the fund. Try to save as much as you can afford, but without being so ambitious that you’ll end up having to cancel or reduce deposits. It may be helpful to think of the contribution in terms of a percentage of your income, so you can scale it easily when your pay increases.
Options to consider when shopping for a Roth IRA include:
- Opening fees. You can find plenty of Roth IRA plans that make it free to open an account. Some charge opening fees, however, so make sure to ask. In general, it’s a good idea to check out all fees involved anytime you’re opening a retirement or investment account.
- Investment-fund types. There are a wide variety of investment vehicles available through Roth IRAs, from funds that let you own and trade individual stocks, to mutual funds and exchange-traded funds focused on various industries, to managed funds designed to maximize yields over fixed timelines (20 years, for college savings, 40 years, for retirement, etc.). Different Roth IRAs offer different funds, so look into the options and pick the fund that works best for you.
- Degree of fund management. Fund-management options run the gamut from no-frills, do-it-yourself discount brokerages to accounts actively managed by experts (who command handsome fees). Discuss the options at the fund providers you’re considering, and find the option that works best for you.
- Minimum opening balances and fund balances. Some Roth IRAs require a minimum opening deposit that may be larger than the amount of your regular weekly contribution. Furthermore, some mutual funds and other investment vehicles available through Roth IRAs require minimum fund balances, or “buy-in” amounts. Choosing a fund with a sizable fund balance could delay any investment returns until you accumulate enough contributions to buy in.
These options can be confusing, but staff at institutions that offer Roth IRAs should be able to guide you through the process. Make sure they answer all your questions, and that you feel good about your decisions. If you’re feeling pressured or uncomfortable, go elsewhere; there are plenty of Roth IRA providers to choose from.
If you think additional guidance might be helpful in selecting the Roth IRA that’s best for you, consider consulting the National Association of Personal Financial Advisors (NAPFA) to find a professional in your area.
If a Roth IRA is in your future, there’s a good chance a prosperous retirement will be as well.
Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer, or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.