When the time comes to start thinking about investing in a retirement account, you may want to take a closer look at an Individual Retirement Account. There are two main forms, the traditional IRA and the Roth IRA. Both offer key benefits, the Roth IRA is one of the best options for many people. Take into consideration when you may wish to use this method.

Who Should Consider a Roth IRA?

If you do not have a retirement account from an employer, investing in one that you can open yourself is worthwhile. Employer-sponsored plans, such as 401(k)s can be a good option if you have access to them, but many people who work for themselves or work for an employer that does not offer them still need to consider the options in retirement planning. Because retirement accounts offer key benefits – including the ability to reduce your tax obligations later in life, they should be available. Note, if you work for yourself or are a small business owner, you may need to learn more about a SEP IRA.

A Roth IRA is a good option for anyone who:

  • Is younger and plans to invest long term
  • Is likely to have an income under the annual threshold
  • Is likely to have a higher tax bracket later in life and wants tax-free withdrawals

It’s important to understand how they work to know whether a Roth IRA is the best choice for your needs.

How Does a Roth IRA Work?

Once you open your Roth IRA, you can begin to put money into the account. You contribute after-tax dollars. That means you are investing money into this account that you are already paying taxes on during the year. If you have an employer, for example, your employer pays taxes on your earnings, and then you invest funds into your Roth IRA account.

When you begin to take withdrawals from your retirement account, you will not have to pay taxes on those withdrawals. That’s a key difference between the traditional IRA and the Roth IRA. With traditional IRAs, you invest pre-tax dollars and pay taxes later in life when you begin to take withdrawals from the account.

How Does a Roth IRA Make Money?

The goal of any investment account is to make money. The Roth IRA does this in several ways. First, you will make contributions to your Roth IRA on a consistent basis (in most cases) to benefit from the account. That means you are contributing money each year to build the base value.

Second, there are investments that are used to build the value of the account. The money you put into the account is then used by the brokerage to invest in underlying investments such as ETFs. Most of the time, this is a mixture of high-, low-, and mid-risks, giving you the ability to choose how much risk is right for your situation.

The types of investments are flexible. You usually get to pick the types of investments you want to make, too. Some accounts provide easy access to this and allow you to allocate various amounts of money to various types of investments, again depending on your risks.

Most Roth IRAs will include investments such as individual stocks, mutual funds, and bonds. In some cases, you can also invest in options, but this is a highly aggressive form of investing that is generally not used for most retirement accounts.

If the underlying investments do well, your retirement account’s value raises. Because retirement investing is a long-term strategy, it will likely build value over time. How much it earns depends on how well the underlying accounts do.

How Much Can You Contribute to a Roth IRA?

Roth IRAs have some limits. Most retirement accounts have limits on the amount of money you can put into them. This helps to minimize the risk of people abusing the system. Keep in mind that these limits are set each year. The Internal Revenue Service (IRS) communicates these limits to you in the year prior to the tax year. Generally speaking, they adjust with inflation.

For the tax year 2019, the maximum amount you can contribute to your Roth IRA is $6,000. If you are over the age of 50, you are able to contribute as much as $7,000. This is called a catch-up payment and is meant to help those who are older to invest a bit more to build up their retirement account balance faster.

Are Roth IRA Contributions Tax Deductible?

One key thing to remember about Roth IRAs is that the contributions you make during the year are not tax deductions. This is different from the traditional IRA. If you open a traditional IRA, you can deduct the amount you put into your IRA each year on your federal and state income taxes. This is not the case with a Roth IRA. That is an important factor to speak to with your tax professional about before you make the decision to choose this type of retirement account.

When Can You Withdraw Funds from a Roth IRA?

Withdrawing money from any type of retirement account is something to do when you are older. It is meant to be a way for you to save for retirement. That is why there are some penalties associated with withdrawing money from retirement accounts too soon.

With a Roth IRA, you are able to withdraw funds from your account before you reach your retirement age (which is defined by the IRS based on your birth year). Keep in mind that you can take money out of your account before that age because the funds you’ve invested are already taxes.

However, if you take money out prior to the age of 59 ½ years old, you will have a fee. This is a 10 percent penalty that the IRS charges at the time that you withdraw the funds. That’s because the tax advantages are meant to be available to those who are using the money for retirement.

Want to Retire Early?

One of the benefits of a Roth IRA is that you can withdraw those funds when you reach 59 ½ years of age. That means you can begin to take money out of your account – and retire early as a result – at a much younger age than with a traditional IRA. When you reach this age, you can withdraw from your account tax-free. There are no taxes paid at the time of your withdrawals.

Education Costs

Another important benefit that the Roth IRA offers is the ability to use the funds in your account for a qualified education expense. For example, if you wish to pay for your own college education using the funds, you can do so. If you wish to pay for your child’s college tuition, you can do that, too. As long as it is considered a qualified education expense – under the IRS rules, the funds can be used for that need without regard to age.

Income Eligibility Requirements for Roth IRAs

Keep in mind that not everyone is able to open a Roth IRA and contribute to it. The IRS puts in place income requirements. If you make beyond this amount, the Roth IRA investment method is not available to you. In 2019, a single tax filer or a head of household tax filer is allowed to make no more than $118,000 per year. If you make more than this, but less than $132,999, you may still use a Roth IRA, but the amount you can contribute to it is less than $6,000 per year (there is a step-down level based on your income in this threshold). If you make over $133,000, though, the Roth IRA is no longer available to you.

If you are married and filing jointly, you can contribute to a Roth IRA if you earn up to $186,000. There is a reduced contribution level available for those who earn between $186,000 and $195,999. If you earn more than $196,000 under this tax filing, you cannot contribute to a Roth IRA.

Income Changing?

Some people may be earning under the Roth IRA limits right now but may anticipate earning more than this over time. Opening a Roth IRA now, while your income is as low as possible, is then ideal. Contribute as much as allowable during this time. Then, when you reach the threshold, open a traditional IRA to begin contributing to. This way, you can get as much into your Roth IRA as possible before it becomes inaccessible to additional investments.

Comparing a Roth IRA to a Traditional IRA

As noted, the traditional IRA is the other form of IRA available today. Both are considered IRAs, and both are available to those who wish to open their own account. Here are a few ways they differ and how that can impact your decision about which one is right for you.

Who Can Contribute?

As noted, the Roth IRA has income limitations. If you do not fall within those income requirements, then it is best to open a traditional IRA. There are no income limits for traditional IRAs.

Withdrawal Requirements

The Roth IRA does not require you to take withdrawals from your retirement account at any time. That is why many people use it as a way to fund their inheritance to another person. However, with a traditional IRA, you are forced to begin taking withdrawals at the age of 70 ½ years of age, if you have not done so prior to this age.

Tax Deductions

The Roth IRA does not allow you to take any tax deductions during the year that you invest the money. The traditional IRA does allow this. If you want to reduce your income taxes on an annual basis, the traditional IRA may be a better option.

When Are They Taxed?

The Roth IRA is taxed before you invest the money into the IRA. It grows without taxes throughout the rest of your life. The traditional IRA is funded with pre-tax dollars. The funds are then taxed when you withdraw the funds during your retirement.

It is important to know which type of IRA is best for you. Many people will find that the Roth IRA offers a lot more flexibility than the traditional IRA, making it an excellent investment for those who are looking for long-term earning without the need to pay taxes later.

Author

Edwin is the founder of Voy Media. He started his career at an investment bank before moving to the biopharmaceutical industry. He is currently an editor at Dollar Genie, a finance blog that teaches you how to save money, make money, and live well.

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