A Roth IRA is an after-tax retirement account, in contrast to a traditional IRA or most 401(k)s, where contributions are made on a pre-tax basis. A Roth IRA is best for low- to middle-income Americans who don't want to worry about income taxes in retirement and want the increased flexibility that comes with a Roth IRA.
What is a Roth IRA and how does it work?
A Roth IRA is an individual retirement account (IRA) that works a little differently than most other types of retirement savings accounts. Specifically, while most other retirement contributions are tax deductible, Roth contributions are not. Instead, withdrawals in retirement are tax-free. This essentially allows investors to pre-pay their taxes now, so they don't have to worry about it later on.
For the 2016 tax year, Roth IRA contributions are limited to $5,500 per person, with an additional $1,000 "catch-up" contribution allowed for individuals over 50, for a total of $6,500. It's important to note that there is no such thing as a "joint IRA," (hence the "I" in IRA) so you and your spouse will each need your own account. And, these contribution limits apply across all IRAs you own. In other words, if you contribute $3,000 to a traditional IRA, you can contribute $2,500 to a Roth IRA to stay within the $5,500 limit.
Contributions can be invested in virtually any stocks, bonds, or mutual funds you can think of, or can be left in cash or money market instruments. Investments held in a Roth IRA, or any other qualified retirement account, grow on a tax-deferred basis, meaning that they aren't subject to capital gains or dividend taxes on an annual basis.
Benefits to a Roth IRA
There are several big advantages to saving for retirement in a Roth IRA. For starters, because you've already paid taxes on Roth IRA contributions, qualified withdrawals from the account in retirement are 100% tax-free as long as it's been open for at least five years.
Furthermore, for the same reason, your contributions are not tied up in the same way traditional IRA contributions are. You are allowed to withdraw Roth IRA contributions at any time, and for any reason, without paying a penalty to the IRS.
Roth IRA contributions also have no age restriction. Whether you're still earning money or not, you have to stop contributing to a traditional IRA when you turn 70 1/2, but no such restriction exists for a Roth IRA. Similarly, a Roth IRA has no required minimum distribution (RMD) rule. You don't have to start withdrawing from the account until you're ready -- or not at all. For this reason, a Roth IRA can be a great estate-planning tool that can help investments you plan to leave to heirs grow tax-free.
Finally, a Roth IRA eliminates uncertainty when it comes to taxation. Although it may not seem like it, the U.S. tax brackets are actually rather low in a historical context. It wasn't that long ago that tax rates of more than 50% for high earners existed, and this could certainly happen again. However, money in a Roth IRA will be tax-free, no matter what the tax rates are when you retire.
Drawbacks to the Roth IRA
The most obvious downside to a Roth IRA as opposed to most other types of retirement accounts is the lack of an immediate tax benefit. We've already discussed how the future tax benefit helps to offset this, but it's still worth considering, especially if your priority is lowering your current tax bill.
In addition, the ability to contribute to a Roth IRA is subject to income limitations. As of the 2016 tax year, the income limit to make a full contribution is $117,000 if you're single and $184,000 if you're married filing a joint tax return. The ability to contribute disappears completely above $132,000 and $194,000, respectively. Here is a complete discussion of the Roth IRA income limits and one way to get around them if your income is too high.
In a nutshell, both traditional and Roth IRAs have their pros and cons, so it's important to evaluate which type of IRA will be best for you.
How to get started
Roth IRAs are offered by most major brokerages and financial institutions. Commissions and fees can vary significantly between the companies offering Roth IRAs, so it's important to compare your options before deciding. Here is a guide to help you through the process, from opening an account to making your first Roth IRA investments.
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