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A Roth IRA is a type of individual retirement account you can open on your own, as opposed to an employer-sponsored account such as a 401(k). Depending on your income and other factors, a Roth IRA can be a great way to save for retirement.
You'll have many choices to make when planning for retirement, so it's important to know your options, and what sets apart a Roth IRA. With a Roth IRA, your earnings will be tax-free since you contribute to the fund with after-tax dollars. Because of this tax advantage, you can't contribute to a Roth IRA if you earn more than a certain amount in a year. A Roth IRA is a good option for those just starting out and paying less in taxes than they expect to later in life.
Here's what you need to know about saving with a Roth IRA, when it can be a good idea and how to contribute.
How a Roth IRA Works
With a Roth IRA, the money you contribute is invested in stocks, mutual funds, exchange-traded funds or other vehicles. These grow as the market grows. (Your account can also include less-risky choices such as cash and bonds, which don't have the same potential for growth.)
Historically, the stock market has provided an investment return of 10% annually, or about 7% once adjusted for inflation. That means you can expect your money to grow an average of about 7% per year when invested—though some years will see more robust returns, and others leaner.
When you open a Roth IRA, a bank, credit union or brokerage will host the account, and you'll choose the type of investments you want to make. Some Roth IRA providers will help you pick investments based on your age and risk tolerance; investing in more stocks, for instance, is a wiser choice for younger investors who have more time to ride out ups and downs in the stock market.
You might have access to a 401(k) retirement account through your employer, which can make deposits for you via paycheck deductions. A Roth IRA is different from a 401(k) in the following ways:
- It's an individual account, not tied to a workplace benefit program.
- The maximum contribution for 2019 is $6,000, or $7,000 if you're 50 or older. The contribution limit for a 401(k) is $19,000.
- You won't be able to contribute to a Roth IRA if your total income minus deductions is more than $137,000 per year and your tax filing status is single, or $203,000 per year if you file taxes jointly with a spouse. There are no income limits on a 401(k).
- You must start taking distributions from a 401(k) when you turn 70 1/2, whereas there's no age requirement for distributions from a Roth IRA.
Don't confuse a Roth IRA with a Roth 401(k), which is an option your employer may offer in addition to a traditional 401(k) plan. A Roth 401(k) provides a similar tax treatment as a Roth IRA (you contribute with after-tax dollars), while contributions to a traditional 401(k) are made pre-tax. Paying tax sooner rather than later reduces your taxable income in the year you contribute, but you'll then pay income tax on withdrawals from a traditional 401(k) when you retire.
What Is the Difference Between a Roth and a Traditional IRA?
An individual retirement account (IRA) is a strong choice if you don't have access to an employer-sponsored account, you want to supplement it, or you want more investment options.
There are two types of individual retirement accounts to choose from: Roth and traditional. The primary differences are that Roth IRAs have income limits, traditional IRAs require withdrawals starting at age 70 1/2, and you'll pay income tax on withdrawals from traditional IRAs in retirement. Explore more differences in the table below.
|Roth IRA||Traditional IRA|
|Maximum annual contribution (2019)||$6,000 ($7,000 if age 50 or over by end of year)||$6,000 ($7,000 if age 50 or over by end of year)|
|Maximum income allowance||$137,000 for individuals filing as single; $203,000 for married couples filing jointly||None|
|Contributions tax-deductible?||No||Maybe, depending on your income and whether you have a retirement plan at work|
|Withdrawal of contributions subject to income tax?||No||Yes|
|Withdrawal of fund earnings subject to income tax?||Maybe, if withdrawals are made before age|
|Early withdrawal penalty?||Some withdrawals of fund earnings made before age|
59 1/2 are subject to 10% penalty
|10% penalty on some withdrawals made before age|
|Age restriction on contributions||None||70 1/2|
|Age when distributions become mandatory||None||70 1/2|
What Are the Benefits of a Roth IRA?
Roth IRA savings are post-tax contributions: You've already paid taxes on the funds you're contributing to a Roth. That means 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 your Roth IRA has been open for at least five years. If the amount in the fund has grown, that can mean major tax savings.
Roth IRAs can be especially beneficial to people just starting in their careers, when their incomes—and income tax rates—are lower than they may be later on. 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 in retirement, when their income and tax rate are usually lower.
Another advantage of Roth IRAs is that they can be opened on behalf of a spouse or children. There is no minimum eligibility age, so contributions made while your child is young can grow tremendously over a lifetime. To qualify, the child must have earned income. Allowances don't count, but wages and tips from part-time jobs do. The amount placed in a child's Roth IRA cannot exceed his or her earned income in a given year. The child may have to file taxes each year Roth IRA contributions are made for them.
A Roth IRA also can be used to pass wealth to heirs, as you can name multiple beneficiaries to your account. Beneficiaries must take required minimum distributions from the account after your death, but younger beneficiaries can take smaller distributions over a longer time period—allowing funds in the account to continue tax-advantaged growth.
How Much Can I Contribute to a Roth IRA?
You can save up to $6,000 ($7,000 if you're 50 or older) per year in a Roth or traditional IRA, or in a combination of both. That's in addition to the maximum contribution of $19,000 you can make to any employer-sponsored retirement plan you may have.
The amount you contribute to a 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.
Do I Qualify for a Roth IRA?
There are limitations on who can participate in a Roth IRA, and they're based on your 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 contribute the full annual amount to a Roth IRA if you are single and have a MAGI of less than $122,000. If you are married and file taxes jointly, your combined MAGI must be less than $193,000. Individuals with an income between $122,000 and $137,000—and couples with joint incomes between $193,000 and $203,000—can participate in a Roth IRA, but at a reduced amount.
How to Open 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 study the options carefully and ask lots of questions to determine which 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 as your pay increases.
Factors to consider when shopping for a Roth IRA include:
- Fees. You can find plenty of Roth IRA plans that make it free to open an account. Check the plan's management or per-trade fees too. In general, it's a good idea to evaluate all fees involved anytime you're opening a retirement or investment account.
- Investment fund types. There is a wide variety of investment vehicles available through Roth IRAs, including funds that let you own and trade individual stocks, mutual funds and exchange-traded funds focused on various industries. Explore your options and pick the fund that works best for you and your investment goals.
- 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 may command high fees). Discuss the options with the fund providers you're considering, and make sure they match your style of investing.
- 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. Some mutual funds and other investment vehicles available through Roth IRAs also 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 all your questions are answered and 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.
The Bottom Line
A Roth IRA is just one of many retirement savings options. But thanks to its tax advantages and flexibility in distribution timing, it's one that is a smart choice for many—even if it's in addition to a workplace-sponsored plan that provides matching contributions. Committing to saving for the future may be the hardest part; once you've decided to prioritize your retirement, setting the money aside will soon become second nature.