Although we'd like to think our path to retirement involves going from Point A to Point B in a straight line, the actual route many of us take winds up looking like a game of Chutes and Ladders. Unexpected medical costs, expenses associated with starting a family, and student loan debt are all examples of big costs that can derail our straight-and-narrow retirement plans.
Thankfully, a number of great retirement tools exist to give Americans an edge when it comes to aiming for their pie-in-the-sky retirement goals. Among them, the Roth IRA just might be the greatest. If you're curious about opening a Roth IRA and building your nest egg, then these 11 fast facts are what you need to know.
1. There's an annual contribution limit
The first thing you need to know is that you can't throw your entire life savings into a Roth IRA. In 2016, the maximum contribution limit for Americans is $5,500. This is a dynamic number set by the Internal Revenue Service that tends to change with the rate of inflation every couple of years.
2. But you can contribute more if you're older
However, if you're age 50 or older, you're also entitled to what's known as a "catch-up" contribution. This catch-up clause is worth an extra $1,000, meaning older working Americans and seniors can contribute up to $6,500 in 2016.
3. No age limits
Unlike the traditional IRA, which disallows regular contributions starting the year you turn 70-1/2, Roth IRAs have no age limit when it comes to regular contributions. With Americans regularly living into their 80s, 90s, and 100s, a Roth IRA is a tool that allows for ongoing contributions.
4. Income limits could prevent your contribution to a Roth IRA...
You should also understand that not everyone will be able to open, or contribute to, a Roth IRA based on their modified adjusted gross income (i.e., after deductions and credits are accounted for). In 2016, single filers' Roth contributions could be limited if their MAGI falls between $117,000 and $131,999. A MAGI of $132,000 or above makes single filers ineligible for a Roth IRA contribution. For joint filers the phaseout begins at $184,000, with couples becoming ineligible at $194,000 MAGI.
5. ...but there's a way around income limits
The good news is Roth IRA income limits don't have to stop you -- but they may slow you down a bit. Anyone, regardless of income, can open and contribute to a traditional IRA. Subsequently, a traditional IRA can be rolled over into a Roth IRA, since there are no income limits on conversions. What you need to keep in mind is that you can only roll over money from one IRA to another once within a 12-month period, thanks to new regulations implemented in 2015. You'll also pay income tax on the contributions you made to the traditional IRA if they were deductible at the time you made them.
6. Your eligible withdrawal age
Regardless of whether you invest in a Roth IRA or traditional IRA, the age at which you become eligible to begin taking regular withdrawals is 59-1/2. But as you'll see below, with a Roth IRA certain types of early, penalty-free withdrawals may be possible.
7. Tax-free in, tax-free out
With a traditional IRA, an early withdrawal before age 59-1/2 will likely be met with a 10% penalty on top of ordinary income tax. This makes sense given that traditional IRA contributions are in pre-tax dollars. With a Roth IRA, account holders can pull out what they've contributed to a Roth IRA at any time without tax or penalty (not including investment gains) since the money contributed is after-tax income. These contributions would probably be best left alone over time, but in a pinch they could be used for a mortgage or college tuition payment.
8. The five-year rule
However, when it comes to earnings and interest generated within a Roth IRA, account holders are required to wait five years before making a withdrawal. Failing to follow the five-year rule could make your distribution unqualified and expose your withdrawal to federal taxes. This five-year rule applies to contributions, as well as conversions, to a Roth IRA.
9. Minimum withdrawals aren't required
One of the more enticing aspects of a Roth IRA is that minimum distributions aren't required. If you choose, you can let your Roth IRA grow unfettered without making a single withdrawal. Combined with no age limit for contributions, it's easy to see why Roth IRAs can be such a powerful retirement tool. By comparison, a traditional IRA does require a minimum distribution beginning at age 70-1/2.
10. You could save a lot on your taxes in your golden years
Of course the best thing about a Roth IRA is that if you follow the rules, none of your distributions beginning at age 59-1/2 or after are taxable. If you begin contributing to a Roth IRA early in your working career, you could wind up saving hundreds of thousands of dollars thanks to time and compounding.
11. Contributions can be made retroactively for tax purposes
Lastly, contributions to a Roth IRA (as well as a traditional IRA) can be made well beyond the confines of a typical calendar year. Normally, all tax moves for a current calendar year need to be completed by 11:59 p.m. on Dec. 31. With a Roth IRA or traditional IRA you can contribute up to Tax Day the following year (e.g., April 18, 2016) and retroactively apply that contribution to the prior calendar year (i.e., 2015). Essentially you have no excuses for not maximizing your contribution.
Is a Roth IRA the best retirement tool for you? Leave your thoughts in the comments below.