What is a Roth IRA?

What is a Roth IRA?

   Quick Summary

→  There are two major types of IRAs – Traditional IRAs and Roth IRAs. A Roth IRA is a type of retirement savings account that has no upfront tax benefit (i.e. no tax deduction), but it allows you to invest tax free year-in-and-year-out and eventually take tax free withdrawals later on in life.

→  Roth IRAs can be a very effective way to save for retirement, but they are not for everyone. If you want to learn more about your retirement saving options, check out our article “Roth IRAs vs. Traditional IRAs: What’s the Difference?”.

Roth IRA Basics

A Roth IRA is a tax-efficient way to save for retirement.  They have two major advantages:

  1. Tax Free Withdrawals like a Traditional IRA, you can invest your money in a Roth IRA free of tax on gains, interest and dividends. The difference, however, is that with a Roth IRA you are allowed to eventually withdraw or take money out of the account and not pay any income tax. With a Traditional IRA you almost always pay tax on withdrawals. 
  2. No Required Minimum Distributions – the IRS does not require you to start taking mandatory withdrawals from your Roth IRA at a certain age. With Traditional IRAs, you are required to start taking annual withdrawals at age 72, even if you don’t need the money. These are called Required Minimum Distributions.

Are Roth IRAs really tax free?

So what’s the catch? It sounds almost too good to be true. Do you really never pay taxes on any Roth IRA money??

Naturally, there are caveats. Uncle Sam needs to get his cut one way or another.

With a Roth IRA, there is no upfront tax deduction for contributions. This is different from a Traditional IRA, where generally you can take a tax deduction for any contributions you make. 

When you contribute to a Roth IRA you are using after-tax money, i.e. money that has already been taxed. Think of it another way – if you contribute $5,000, you are really using $5,000 that has been taxed elsewhere, such as through payroll taxes on your paychecks. Uncle Sam takes his cut upfront.

And as mentioned above, not all distributions are tax free. You might have to pay taxes and a 10% penalty if you take money out  prematurely, which is generally classified as being under 59 1/2 years old (unless you use it for a specific exception, like medical bills, college, or a first time home purchase).

The good news is that if you’re under 59 1/2 and really need access to Roth funds for a reason that isn’t a qualified exception, you are allowed to withdraw your original contributions tax and penalty-free. For example, if your account is $10,000, of which $6,000 is how much you contributed to the account and the other $4,000 is investment growth, you would be allowed to take out that $6,000 of contributions at any time and not have to pay tax or a 10% penalty.

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How Much Can I Contribute each year?

In 2020 the most you can contribute to a Roth IRA is $6,000. If you are over 50 you can put in an extra $1,000, for a total of $7,000. The IRS usually increases these limits each year so it’s possible next year you could contribute even more.

This limit is across the board for all IRAs. You cannot put $6,000 into a Traditional IRA and $6,000 into a Roth IRA in the same year. You can contribute to both types, it’s just that the total between the two cannot be more than $6,000 

Who is Eligible to Contribute?

Not everyone can contribute to a Roth IRA.

You must be under a certain income level in order to contribute. It’s based on your marital status as follows:

  • Single – cannot make more than $139,000. If you make between $124,000 and $139,000 you can only make a partial contribution.
  • Married – cannot make more than $206,000. If you make between $196,000-$206,000 you can only make a partial contribution.

Income is not just your salary or wages – the IRS looks at your Modified Adjusted Gross Income (AGI), which includes things like interest, dividends, and capital gains. However, if your only source of income is “passive” sources like interest, dividends, and rental properties you cannot contribute at all to a Roth IRA. You must have earned income. Earned income is things like salary, wages, commissions, tips, freelancing or gig work.

Check out this cool infographic to see if you’re eligible to contribute to a Roth this year.

Can a spouse who doesn't work contribute to a Roth IRA?

Yes! If one spouse works but the other does not, you are still allowed to contribute to a Roth IRA for the non-working spouse. 

Conclusion

Roth IRAs are an appealing retirement savings option. If you like the idea of a tax-free source of income in retirement then you should strongly consider using one. However, they are not for everyone. If you need help deciding which retirement account is right for you, make sure to check out our follow up article here – “Roth IRA vs. Traditional IRAs”.

Saving for retirement is a must for most people these days, so make sure you know the pros & cons of all your options to make the best decision for you.

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Disclosures1:

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