What Is Roth IRA (And How to Open One)

☞ What is a Roth IRA?

A Roth IRA is a type of retirement savings account that offers special tax benefits. Unlike some other accounts, with a Roth IRA, you put in money that you’ve already paid taxes on.

The great thing is that any money you make from your investments and the money you put in can grow without you owing any taxes on it. Once you’re 59½ years old and your Roth IRA has been open for at least five years, you can take out the money without having to pay any taxes.

So, you pay taxes on the money you put in at the start, but later on, you can take out all the money without worrying about taxes.

Roth IRAs are similar to traditional IRAs, which are accounts used to save for retirement, but the big difference is in how they’re taxed. With a Roth IRA, you use money you’ve already paid taxes on to fund it.

This means the money you put in doesn’t get you a tax break right now, but it’s a good deal in the long run because you won’t have to pay taxes on the money you take out later.

How Does a Roth IRA Work?

A Roth IRA is a retirement savings account where you can put in money that you’ve already paid taxes on.

This money will then grow over time, and when you decide to take it out after you retire, you won’t owe any more taxes on it.

You can fund a Roth IRA using various methods:

1. Regular Contributions: You can simply put in money from your regular earnings into the Roth IRA.
2. Spousal IRA Contributions: If you’re married, even if only one spouse works, you can contribute to a Roth IRA for both of you.
3. Transfers: You can move money from other retirement accounts into a Roth IRA.
4. Rollover Contributions: When you change jobs or retire, you can roll over funds from a 401(k) or another retirement plan into a Roth IRA.
5. Conversions: You can convert money from a traditional IRA to a Roth IRA, but you’ll need to pay taxes on the converted amount.

It’s important to note that all regular contributions to a Roth IRA must be in the form of cash, like checks or money orders. The IRS sets limits on how much you can deposit into any type of IRA each year, and these limits can change over time.

The contribution limits are the same for both traditional and Roth IRAs. Remember, these limits apply to all your IRAs combined, so you can’t contribute more than the maximum allowed.

Unlike other retirement accounts, the money you invest in a Roth IRA grows without you needing to pay taxes on the growth.

Another advantage of a Roth IRA is that you’re not forced to take out a minimum amount each year (required minimum distributions) during your lifetime, as you would with 401(k)s and traditional IRAs.

In contrast, with a traditional IRA, the money you put in is usually not taxed until you withdraw it in retirement, giving you a tax deduction when you contribute.

What can I invest in with a Roth IRA?

Once you’ve contributed funds, a Roth IRA provides a range of investment possibilities. These include mutual funds, stocks, bonds, exchange-traded funds (ETFs), certificates of deposit (CDs), money market funds, and even cryptocurrency.

However, it’s important to note that while you can’t directly contribute cryptocurrency to your Roth IRA according to IRS rules, there are special retirement accounts known as “Bitcoin IRAs” that allow cryptocurrency investments.

Keep in mind that the IRS has specific restrictions on certain assets within an IRA. For instance, life insurance contracts and derivative trades are not permitted.

To expand your investment choices to their fullest, you can opt for a Roth self-directed IRA (SDIRA).

This specialized category of Roth IRA empowers you, rather than a financial institution, to manage your investments. With a Roth SDIRA, you can explore a wide array of investment opportunities.

In addition to conventional investment options like stocks, bonds, cash, money market funds, and mutual funds, a Roth SDIRA enables you to hold assets that typically aren’t part of a traditional retirement portfolio.

This includes investments like gold, real estate, partnerships, tax liens, and even owning a franchise business.

Remember that the maximum annual contribution to a Roth IRA in 2023 is $6,500 for individuals, with those aged 50 and above having the option to contribute up to $7,500.

These limits apply across all IRAs you may have.

☞ How to open a Roth IRA

To start a Roth IRA, you’ll need to choose an institution approved by the IRS to offer IRAs. This includes banks, brokerage firms, federally insured credit unions, and savings and loan associations.

Typically, individuals opt for brokers when opening IRAs.

The process of establishing a Roth IRA is flexible, allowing you to set it up at any time. However, contributions for a specific tax year must be made by the IRA owner’s tax-filing deadline, which usually falls on April 15 of the following year.

Two essential documents are provided to you when you establish an IRA:

1. The IRA disclosure statement.
2. The IRA adoption agreement and plan document.

These documents outline the operational rules and regulations of your Roth IRA and establish an agreement between you as the IRA owner and the IRA custodian or trustee.

It’s important to note that not all financial institutions offer the same services. Different IRA providers have varying investment options and fee structures that can significantly impact your investment returns.

Your personal risk tolerance and investment preferences should guide your choice of a Roth IRA provider.

If you intend to be an active trader, look for providers with lower trading costs. Some providers even charge inactivity fees if your investments remain untouched for a certain period.

Additionally, various providers offer different ranges of stocks or ETFs, so your decision should align with the investments you plan to have in your account.

Take into account specific account requirements. Minimum account balances can differ among providers.

If you plan on using the same institution for other banking needs, explore whether your Roth IRA account comes with additional banking products.

For existing customers considering a Roth IRA with their current bank or brokerage, it’s worth checking whether any IRA fee discounts are offered.

Most IRA providers primarily offer regular IRA accounts (traditional or Roth). If you’re interested in a self-directed IRA that allows a broader range of assets beyond stocks, bonds, ETFs, and mutual funds, you’ll need a qualified IRA custodian specializing in such accounts.

Are Roth IRAs covered by insurance?

It’s important to note that if your Roth IRA is held at a bank, it falls into a distinct insurance category separate from regular deposit accounts.

Consequently, the insurance coverage for IRA accounts is not as comprehensive.

The Federal Deposit Insurance Corp. (FDIC) still provides insurance protection of up to $250,000 for both traditional and Roth IRA accounts, but the coverage considers the combined balances rather than individual account values.

For instance, consider a banking customer who holds a $200,000 CD within a traditional IRA and a $100,000 Roth IRA in a savings account at the same institution. In this scenario, the account holder would have $50,000 of assets that lack FDIC coverage.

What qualifies as contributions to a Roth IRA?

The IRS not only sets the limits on the amount you can contribute to a Roth IRA but also specifies the sources of funds you can contribute. In essence, you can only add earned income to a Roth IRA.

For those employed by an organization, eligible compensation includes wages, salaries, commissions, bonuses, and other payments received for services rendered.

This typically encompasses amounts displayed in Box 1 of the individual’s Form W-2.

If you’re self-employed or part of a partnership or pass-through business, your compensation is defined as your business’s net earnings, minus any deductions for retirement plan contributions made on your behalf. It is further adjusted by reducing it by 50% of your self-employment taxes.

Additionally, if you receive taxable alimony from a divorce settlement finalized before December 31, 2018, you can contribute funds related to that settlement.

However, some forms of income are ineligible for contributions, including:

• Rental income or profits from property upkeep
• Interest income
• Pension or annuity income
• Stock dividends and capital gains
• Passive income from a partnership where substantial services aren’t provided by you

Remember, your contribution to your Roth IRA cannot exceed your earned income for the tax year.

As previously mentioned, no tax deduction is provided for the contribution, but you might be eligible for a Saver’s Tax Credit of 10%, 20%, or 50% based on your income and personal circumstances.

☞ Can everyone open a Roth IRA?

Individuals with earned income are eligible to open a Roth IRA, provided they meet specific criteria related to filing status and modified adjusted gross income (MAGI).

Those whose yearly earnings exceed a certain threshold, which is adjusted by the IRS at intervals, may be disqualified from contributing. The table below presents the income limits for 2022 and 2023.

Do I qualify for a Roth IRA?

For those who earn less than the ranges mentioned for their category, they can contribute up to 100% of their earnings or the contribution limit, whichever is lower.

If you fall within the phaseout range, you need to subtract your income from the maximum level, then divide that by the phaseout range to find out the percentage of $6,500 that you can contribute.

Boost contributions with a Spousal Roth IRA

Couples have a way to enhance their savings through the spousal Roth IRA. If one spouse earns little or no income, the other can contribute to a Roth IRA on their behalf.

This follows the same rules and limits as regular Roth IRA contributions.

Remember, Roth IRAs can’t be joint accounts; they’re held separately.

To qualify for a spousal Roth IRA contribution, these conditions must be met:

1. The couple must be married and file a joint tax return.
2. The contributing spouse must have eligible compensation.
3. The combined contributions of both spouses can’t exceed the taxable compensation reported on their joint tax return.

While contributions to a single Roth IRA can’t surpass the contribution limits for one account, having two accounts enables the family to double their annual savings.

☞ Qualified distribution withdrawals

Withdrawing contributions from your Roth IRA, tax- and penalty-free, is possible at any point during the tax year.

If you withdraw an amount equal to your contributed sum, the distribution isn’t taxable income and isn’t penalized, regardless of your age or how long it’s been in the account.

However, a twist applies to account earnings—any returns generated.

For a distribution of account earnings to be considered qualified, it must fulfill these conditions:

1. The distribution takes place at least five years after establishing and funding the first Roth IRA.
2. The distribution meets one of these conditions:
   • The account owner is at least age 59½ during the distribution.
   • The assets are used to buy, build, or rebuild the Roth IRA owner’s first home, limited to $10,000 per lifetime, for the owner or a qualified family member.
   • The distribution follows the account owner’s disability.
   • The beneficiary of the Roth IRA owner receives the assets after their death.

The 5-year rule for withdrawals

When it comes to withdrawing earnings, potential taxes and a 10% penalty could be in play, contingent on your age and whether the five-year rule has been met. Here’s a concise overview:

If the five-year rule is met:

• Under age 59½: Earnings are subject to taxes and penalties. Exceptions include using the funds for a first-time home purchase (limited to $10,000 lifetime), permanent disability, or passing away with your beneficiary taking the distribution, which might avoid taxes and penalties.
• Ages 59½ and older: No taxes or penalties apply.

If the five-year rule isn’t met:

• Under age 59½: Earnings face taxes and penalties. However, you might escape the penalty (but not taxes) by using the money for a first-time home purchase (up to $10,000 lifetime), qualified education expenses, unreimbursed medical expenses, permanent disability, or if your beneficiary takes the distribution after your passing.
• Ages 59½ and older: Taxes apply to earnings, but not penalties.

Roth IRA withdrawals adhere to a first in, first out (FIFO) method. In other words, contributions are withdrawn before earnings, ensuring earnings are untouched until all contributions are exhausted.

☞ Non-qualified distribution withdrawals

If earnings are withdrawn without meeting the aforementioned criteria, it’s classified as a non-qualified distribution, which could potentially trigger income tax or an early distribution penalty.

There may be exceptions, though, if the funds are utilized:

1. Unreimbursed Medical Expenses: If the distribution is used to cover unreimbursed medical expenses that exceed 7.5% of the individual’s adjusted gross income (AGI).
2. Medical Insurance Payment: In the event of job loss, the distribution can be used for medical insurance payments.
3. Qualified Higher Education Expenses: If the distribution is directed towards qualified higher education expenses for the Roth IRA owner and/or their dependents. This encompasses tuition, fees, books, supplies, and required equipment for eligible educational institutions, to be used within the withdrawal year.
4. Childbirth or Adoption Expenses: Withdrawals for childbirth or adoption expenses made within a year of the event and not surpassing $5,000 may be exempt.

It’s important to note that withdrawing only the amount of your contributions made within the current tax year, including the earnings on those contributions, results in a reversal of the contribution.

For instance, if you contribute $5,000 in the present year and generate $500 in earnings, withdrawing the principal $5,000 incurs no tax or penalty, while the $500 gain becomes taxable income.

☞ Coronavirus-related distributions

The Coronavirus Aid, Relief, and Economic Security (CARES) Act introduced a unique provision allowing taxpayers to take coronavirus-related distributions from January 1, 2020, to December 31, 2020.

This provision enabled individuals to withdraw up to a total of $100,000 from qualified plans and IRAs. These distributions were aimed at those adversely impacted by the pandemic, either financially or through a family diagnosis.

Qualified individuals who qualified for coronavirus-related distributions included those who:

1. Were diagnosed with SARS-CoV-2.
2. Had a spouse or dependent diagnosed with SARS-CoV-2.
3. Suffered financial impact due to furloughs, quarantine, layoffs, or reduced work hours during the pandemic.
4. Were unable to work due to lack of childcare during the pandemic.
5. Experienced financial impact due to reduced business hours or business closure during the pandemic.

Under this provision, account holders had the option to treat the distribution either as a standard withdrawal without repayment or as a loan with a repayment option.

The distribution was not subject to the 10% early distribution penalty but was taxable as ordinary income. Taxation of the withdrawal could occur in full in 2020 or spread over three years in 2020, 2021, and 2022.

Those planning to repay the funds had until the end of the third year, with the caveat that taxes on the distribution would still need to be paid until the repayment year.

For instance, consider a $15,000 withdrawal in 2020. You would report $5,000 on your tax returns for both 2020 and 2021. If you fully repay the funds in 2022, the final $5,000 wouldn’t be taxed.

It’s important to note that you’d need to amend your 2020 and 2021 returns to reclaim taxes previously paid on the initial two-thirds.

Opting for a coronavirus-related distribution from multiple retirement accounts could make the Roth IRA an appealing choice. Remember, Roth IRA withdrawals up to contributed funds are tax-free as contributions are after-tax.

Furthermore, the first-in, first-out (FIFO) withdrawal system for Roth IRAs ensures that earnings are untouched until contributions are depleted, resulting in a potentially lower taxable distribution from a Roth IRA.

☞ Roth IRA vs Traditional IRA: Which is right for you?

The choice between a Roth IRA and a traditional IRA depends on your current tax bracket, future retirement tax rate, and personal preferences.1

If you anticipate being in a higher tax bracket during retirement, a Roth IRA could be more advantageous.

This is because the tax savings in retirement could outweigh the current income tax paid. Younger individuals and those with lower incomes might benefit most from a Roth IRA.

Starting to save with an IRA early in life takes advantage of compound interest. Investments and earnings are reinvested, creating a snowball effect of growth.

Consider a Roth IRA if you prioritize tax-free retirement income over an immediate tax deduction when contributing.

Even if you expect lower taxes in retirement, a tax-free income source like a Roth IRA is appealing.

A significant advantage of a Roth IRA is its flexibility for leaving assets to heirs. Assets can grow indefinitely and be passed to heirs tax-free upon death.

Although beneficiaries need to take distributions, they can stretch the tax deferral over a decade or, in certain cases, their lifetimes.

In contrast, traditional IRA beneficiaries face taxes on distributions. Spouses inheriting an IRA can delay distributions until age 73 by rolling the account into a new one.

Some individuals choose Roth IRAs due to concerns about future tax increases. This allows them to lock in current tax rates on conversion balances.

Highly compensated employees with Roth 401(k) plans can also transfer them to Roth IRAs, avoiding taxes and mandatory distributions at age 73.

☞ Roth IRA FAQ

☞ Final thoughts

In conclusion, a Roth IRA serves as a powerful tool for retirement savings.

With the ability to access funds penalty-free after age 59½ and a five-year holding period, as well as for specific life events like home purchases, education, or starting a family, its flexibility stands out.

Though contributions are made with after-tax dollars, this approach grants the advantage of tax-free withdrawals in the future, without the burden of income taxes.

For those projecting a higher tax bracket in their later years, Roth IRAs offer a strategic avenue, ensuring tax-free income unlike the taxable nature of 401(k) or traditional IRA distributions.

☞ References

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