In the world of retirement investing options, there’s one savings plan that stands out head and shoulders above the rest. It’s easy to set up, simple to maintain and comes with tax advantages that enable you to build wealth and increase your retirement savings for the long haul. It is the ROTH IRA.
A Roth individual retirement account allows you to earn tax-free investment growth on your retirement savings.
When you save for retirement in a Roth IRA, you don’t have to worry about a big tax bill in retirement because withdrawals are typically tax-free.
WHAT IS A ROTH IRA?
A Roth IRA (Individual Retirement Arrangement) is a retirement savings account that allows you to pay taxes on the money you put into it upfront.
Roth IRA contributions are made with after-tax dollars, and there is no tax deduction in the year you make the contribution.
HOW DOES IT WORK?
The funds in a Roth IRA grow without being taxed. Withdrawals that are taken after age 59 1/2 from accounts at least five years old are tax-free.
Many people don’t have to pay any income tax on the investment growth they accumulate in a Roth IRA.
Your contributions help, but it’s the power of compounding that does the heavy lifting when it comes to building wealth with a Roth IRA.
Your account has two funding sources: contributions and earnings. The former is the most obvious source of growth, but the potential for dividends and the power of compounding can be even more important.
WHO’S ELIGIBLE FOR A ROTH IRA?
A Roth IRA can be a powerful financial tool to help you prepare for retirement in a tax-advantaged way. But because of income limits in place, this tool isn’t available to everyone.
To contribute up to the maximum allowed in an IRA, you must have a taxable income of less than $125,000.
If your income is above that, you may contribute a reduced amount, though allowed contributions end entirely once your income reaches $140,000.
For married individuals filing jointly, the income limit for the maximum contribution is $198,000, and the income limit to contribute a reduced amount is $208,000. Many workers may eventually see their income increase to the point where they can’t contribute later in their careers.
For that reason, Roth IRAs are a great option for people at the beginning of their investing journey.
WHAT ARE THE BENEFITS OF A ROTH IRA?
Here are the benefits of a Roth IRA:
You’re not required to take distributions at a certain age, unlike the traditional IRA (which requires withdrawals beginning at age 72). You can keep contributing to your Roth IRA if you choose to work past retirement age, as long as your income still falls within the income limits.
You can also choose beneficiaries to inherit your account, and they will be able to withdraw funds tax-free as well.
HOW MUCH MONEY DO YOU NEED TO START A ROTH IRA?
You can contribute up to $6,000 to a Roth IRA in 2022. People age 50 and older can make additional catch-up contributions of up to $1,000 for a total Roth IRA contribution of $7,000. Those who exceed these contribution limits will face a 6% excise tax on the amount over the limit. You can avoid the penalty by withdrawing excess contributions before filing your tax return.
Roth IRA contributions must be made by the due date of your tax return, which is usually around April 15 each year. If you make a contribution between January and April, you can choose to apply the deposit to the previous tax year or the current calendar year.
HOW TO SET UP A ROTH IRA?
- The Roth IRA contribution limit is $6,000 in 2022.
- For people age 50 and older, the Rothcontribution limit is $7,000.
- The Roth IRA contribution deadline is the due date of your tax return.
- Roth IRA income limits are $140,000 for an individual or $208,000 for married couples in 2022.
- Rothcontributions are not tax-deductible.
- The investment growth in a Roth IRA is usually not subject to income tax.
- Withdrawals in retirement are often tax-free.
Step 1: Decide how you want to manage your account, whether that means investing the money yourself or outsourcing. You have three primary options which include:
- Banks. Because most banks offer savings vehicles (like CDs) rather than investments, they are generally not the best place to open an IRA, which should be geared toward long-term growth.
- Robo-advisors. If you want to take a hands-off approach to investing, a robo-advisor and its automated investment process might be appealing.
- Traditional brokers. These offer a more active approach to choosing your investments.
Most online brokers, banks, and robo-advisors offer Roth IRAs.
Step 2: Choose a brokerage or bank to open your Roth IRA account.
Some things to keep in mind when choosing include account maintenance fees, account transfer fees, and whether they offer commission-free ETFs or mutual funds.
Step 3: Invest your money.
If you go the DIY route, choose what you want to invest your money in, be it mutual funds, stocks, bonds, exchange-traded funds (ETFs), or bank savings products. If you want to invest in stocks and bonds, you may want to open your Roth at a brokerage or robo-advisor rather than at a bank.
You can add money over time. A lump sum or smaller contributions over the course of the year are fine, as long as your contributions don’t exceed $6,000 ($7,000 if you’re 50 or older) or your taxable compensation, whichever is smaller. You can also add money to a Roth by rolling over money from another retirement account.
CAN YOU LOSE MONEY IN A ROTH IRA?
Yes, you can lose money in a Roth IRA. The most common causes of a loss include negative market fluctuations, early withdrawal penalties, and an insufficient amount of time to compound. The good news is, the more time you allow a Roth IRA to grow; the less likely you are to lose money.
The most obvious way to lose money in a Roth IRA is to withdraw your money when the stock market is down. This is true for any investment. The solution to this, as you might suspect, is to give your investment more time to ride out the market. But this is easier said than done. This requires discipline and patience.
Also, in order to give yourself more time, you will need to have other funds sitting in retirement. In other words, don’t put all your retirement eggs in one basket. That way, if the investments you hold in your R-IRA go down, you are more likely to have other investments that didn’t suffer the same decline.
You should not invest in a Roth IRA if you are going to need the money before you reach the required retirement age 59 ½. Your Roth IRA is a long-term investment designed to fund your retirement, not the down payment on a new car, or your next vacation.
If your goal is to save money for anything other than retirement, then a Roth IRA is not the proper investment.
The absolute worst thing you can do with your Roth IRA is withdrawn money before you reach retirement age. Why? This is because in most cases, you will incur a 10% penalty fee. There are certain exceptions to the withdrawal penalty.
For instance, if you lose your job, and need to use the money in your Roth IRA to pay for your health insurance premium, you may withdraw it penalty-free using what’s known as a hardship withdrawal.
However, in most cases, you can expect a penalty. So, in an effort to avoid losing money, do your best to let the money in your Roth IRA sit until you are older than 59 ½. Better yet, wait to take a distribution as long as you can.
The more time you give your Roth IRA to grow, the less likely you are to lose money. When it comes to retirement investing, the best thing you can do is to start investing early, continue to invest consistently, and let your money grow for a very long time.
We’re talking decades, if possible. You should expect your investments to have good years and bad years.
One year, you might make a 20% return, and the next year, you might lose a little money. But, given enough time, the interest your investments earn will begin to compound and grow at an impressive rate.
ROTH IRA WITHDRAWAL RULES
Here are a few withdrawal and distribution rules you must follow:
- You can withdraw your original contributions whenever you want, without owing any penalties or taxes, no matter how long your account has been open. That’s because the money you put in is money on which you already paid income tax.
- When you withdraw money from a Roth IRA, the IRS always assumes your original contributions come out first.
- Qualified withdrawals of investment earnings in the account come out tax-free. However, in certain circumstances the IRS may want a piece of those returns, in the form of taxes and a possible penalty, if you withdraw early or otherwise don’t meet the rules for a qualified withdrawal.
- People at least 59½ years old and who hold their accounts for at least five years can take distributions, including earnings, without paying federal taxes.
ARE THERE ROTH IRA INCOME LIMITS?
Workers must earn below certain income cut-offs to be eligible to save for retirement in a Roth IRA. Those who earn less than $140,000 as an individual or $208,000 as a married couple are eligible to make Roth IRA contributions in 2022.
The Roth IRA contribution amount is phased out for those with incomes of more than $125,000 as an individual and $198,000 as a married couple in 2022.
However, there are several ways to bypass these income limits by contributing to a traditional IRA or 401(k) and then converting the funds to a Roth.
IS A ROTH IRA THE SAME THING AS A ROTH 401(K)
Once you contribute money to your Roth IRA, you invest the money and it grows tax-free in your account. Then when you reach a 59 ½, you can take distributions from your Roth IRA without paying taxes on your contributions or earnings.
Roth IRAs are different from employer-sponsored retirement accounts, and many people often use them to supplement an existing 401(k) plan. By having both accounts, investors are taking advantage of both tax benefits.
ROTH IRA VS. TRADITIONAL IRA
If you want an immediate tax break, consider a traditional IRA. If you like the idea of tax-free income in retirement, a Roth IRA is a good idea.
Roth IRAs are a smart savings tool for younger people just starting out because they’re likely to face higher income tax rates as they move along in their careers.
Someone further along on their career path may also like a Roth IRA, because they provide tax-free income in retirement. That provides what some financial advisors call “tax diversification.”
Money stashed in accounts, such as 401(k)s and traditional IRAs, leads to tax bills in retirement. A Roth IRA can offer a convenient way to manage that tax bill; for example, by pulling at least some income from the Roth to avoid being pushed into a higher tax bracket.
WHAT SHOULD ROTH IRA BE INVESTED IN?
To take full advantage of the Roth IRA’s tax-sheltering properties, it’s best to hold investments that would otherwise trigger substantial taxes. Investments with high growth potential, big dividends, or high levels of turnover are prime candidates.
Overall, the best investments for Roth IRAs are those that generate highly taxable income, be it dividends or interest, or short-term capital gains.
Investments that offer significant long-term appreciation, like growth stocks, are also ideal for Roth IRAs.
ARE ROTH IRAS INSURED?
One of the greatest concerns that many people have with putting their money into an investment account is whether it will be safe. The fact is that anytime you invest, you take on the risk you could lose money if your investments perform poorly.
There are still some protections in place to protect you against certain losses.
First, the Federal Deposit Insurance Corporation (FDIC) insurance protects the money in Roth IRAs and other IRAs at FDIC-insured banks. Your money is protected up to $250,000 per depositor per account type.
CAN ANYONE HAVE A ROTH IRA?
You can open a Roth IRA at any age, as long as you have earned income (you can’t contribute more than your earned income). No required minimum distributions. They aren’t subject to the required minimum distributions required from a traditional IRA or 401(k) starting at age 72.
WHO IS NOT ELIGIBLE TO CONTRIBUTE TO A ROTH IRA?
Only earned income can be contributed to a Roth IRA. You can contribute only if your income is less than a certain amount. The maximum contribution for 2022 is $6,000; if you’re age 50 or over, it is $7,000.
WHAT DISQUALIFIES YOU FROM A ROTH IRA?
For single or head of household filers, the phase-out range is $125,000 to $140,000. If your modified AGI is greater than or equal to $140,000, you cannot contribute to a Roth IRA. …
If you make more than $10,000 and file as married filing separately, you cannot contribute in 2022.
CAN YOU CONTRIBUTE TO A ROTH IRA WITHOUT EARNED INCOME?
Generally, if you’re not earning any income, you can’t contribute to either a traditional or a Roth IRA. However, in some cases, married couples filing jointly may be able to make IRA contributions based on the taxable compensation reported on their joint return.
Always remember that Roth IRAs allow you to pay taxes on money going into your account and then all future withdrawals are tax-free. With a Roth IRA, you contribute after-tax dollars, your money grows tax-free, and you can generally make tax- and penalty-free withdrawals.