What is a Roth IRA?

Retirement planning is an important and unavoidable task that you must undertake as soon as you begin your career. Regardless of the nature of your job or your income, saving for retirement is crucial for everyone. The money you set aside today will secure you in your non-working years. This money will help you live with dignity, comfort, and respect. A retirement fund is useful for covering your essential and non-essential expenses, medical costs, as well as ensuring financial security for your dependents and loved ones. If you require assistance and would be open to receiving guidance when it comes to managing your finances, you can reach out to a financial advisor. A financial advisor is an expert when it comes to meting out financial advice and creating a financial plan for you that will enable you to reach your goals.

One of the most popular retirement accounts in America is the Individual Retirement Account, popularly known as the IRA. An IRA can be of two types. The first is a traditional IRA, and the other is the Roth IRA.

This article covers what you need to know about Roth IRA withdrawals, contributions, uses, and will help you understand what is so special about a Roth IRA.

What is a Roth IRA?

A Roth IRA is a retirement account that offers tax-free withdrawals in retirement as long as you hold the account for a minimum of five years and withdraw money after the age of 59.5. You can fund a Roth IRA with your after-tax dollars. The contributions are not tax-deductible, and all qualified withdrawals are tax-free. A Roth IRA is an excellent option if you expect your retirement income to be in a higher tax bracket than now.

Roth IRA contributions & limits are decided every year and can differ over time. As of 2021, you can contribute to a Roth IRA as long as you meet the following income criteria:

- Single tax filers earning a modified adjusted gross income (MAGI) of $140,000 or less are eligible to open a Roth IRA.

- Married taxpayers filing jointly earning a joint MAGI of less than $208,000 are eligible to open a Roth IRA.

As of 2021, the annual contribution limits for a Roth IRA are:

- Individuals under the age of 50 can contribute up to $6,000 per annum.

- Individuals aged 50 or above can contribute an additional $1,000, bringing the total to $7,000 per annum.

How to open a Roth IRA

If you are thinking of opening a Roth IRA, here are the steps you can follow:

  • Check your eligibility: The first step is finding out whether you are eligible for a Roth IRA or not. If you file your taxes as a single taxpayer, your MAGI should be between $125,000 and $140,000. If you file your taxes jointly with your spouse, your combined MAGI should be less than $208,000. If you fall in these income brackets, you can proceed to the next step.
  • Find a place to open your account: You can open a Roth IRA at a bank, credit union, or with an online broker. All options can be suitable depending on your needs. While banks and credit unions offer low risk and low return investments like certificates of deposits, money market accounts, etc., online brokers can offer high-risk and high-reward investments like stocks, mutual funds, etc. You can pick any option as per your risk appetite and future goals.
  • Fill out the application form: You will be required to fill an application form along with details like your name, bank account information, Social Security number, the name and address of your employer, the name, address, and Social Security number of your beneficiaries, etc. You also need to fill an Internal Revenue Service (IRS) form: 5305-R.
  • Choose your investments: This is the most crucial step as you get to build your portfolio. You can choose the investment options that cater to your future financial requirements. Keep in mind to pick investments keeping in mind your risk appetite. If you are uncertain of what to do, you can consult a financial advisor.
  • Pick a contribution frequency: After finishing the above steps, you can proceed to pick a frequency for your contributions. You can select monthly or yearly deductions as per your suitability.

Roth IRA Vs Traditional IRA: What’s the difference?

Here are some differences between a Roth and a traditional IRA:

The primary difference between a Roth IRA and a traditional IRA lies in how these accounts are treated with respect to taxes. In a Roth IRA, the contributions are made from your after-tax dollars, and the withdrawals are tax-free. Contrarily, the contributions towards a traditional IRA are made from your pre-tax dollars, and your withdrawals are taxed in retirement.

Your Roth IRA contributions grow tax-free, whereas traditional IRA contributions are tax-deferred. If you think you would be in a higher tax bracket in retirement, opting for a Roth IRA can benefit you more. However, if you wish to save on tax now, a traditional IRA can be more beneficial.

In addition to this, there are no income limits for contributing to a traditional IRA. But in the case of a Roth IRA, you must not earn (MAGI) more than $140,000 as a single taxpayer and $208,000 as a married and joint taxpayer.

Lastly, you must take mandatory Required Minimum Distributions (RMDs) after the age of 72 if you own a traditional IRA. There are no mandatory RMDs for a Roth IRA.

What should you know before opening a Roth IRA?

The dilemma of if you should apply for a Roth IRA or not is common. However, the following points can give you better clarity with respect to the efficacy of this account:

You can convert your traditional IRA to a Roth IRA. However, you would owe immediate taxes on your previous contributions and earnings. This can be reduced by opting for partial conversions.

You can open an IRA for your child as long as the child is earning income from a part-time job. This could be tutoring, babysitting, waiting tables, etc. Such an IRA is known as a custodial IRA account. Custodial IRAs can help your child cover higher education costs or set up their business at a later stage in life. Opposed to saving at a bank, their savings do not lie idle in a Roth IRA and instead grow over time.

You can also open an IRA for a spouse. If you open a spousal IRA, you can make the same amount of contributions of up to $6,000 (or $7,000 for people aged 50 or older). This can be done even if the spouse does not earn any income. In this case, you can contribute on behalf of your spouse, provided you have an earned income.

There is no age limit for an IRA. Kids can have a custodial Roth IRA. Moreover, you can keep contributing to your Roth account for as long as you want. But you should have an earned income to keep your contributions going.

A Roth IRA can be passed on to your beneficiaries. The withdrawals made by them will also be tax-free, provided the account was kept for at least five years.

You cannot take a loan from your IRA. However, you can withdraw funds for a 60-day period, known as a tax-free rollover. But you must put the money back within this period. You can make one such tax-free rollover every 12 months.

The following types of incomes cannot be contributed to a Roth IRA:

  • Rental income
  • Interest income, capital gains, and stock dividends
  • Pension
  • Annuity income

Lastly, you cannot contribute more than you earn in a financial year.

Frequently Asked Questions:

1. What is the spousal Roth IRA?

A spousal IRA is an account wherein you can make contributions on behalf of your spouse. The spousal IRA is a separate account that you can open and fund for your spouse’s financial security.

2. Can you lose money in a Roth IRA?

Yes, market fluctuations, penalties for early withdrawals, or not giving your money enough time to compound can lead to a loss in a Roth IRA. If you are scared of losing money, you can select low risk investments for your portfolio.

3. What is the downside of a Roth IRA?

The low annual contribution limits and delayed tax benefits can be some shortcomings of a Roth IRA. In addition to this, while some 401(k) accounts offer a loan facility, you cannot take a loan from your Roth IRA. Moreover, early withdrawals before the age of 59.5 also attract a 10% penalty in most cases.

4. Is a Roth IRA suited for people with less income?

A Roth IRA can be used by people for varied income groups. As long as you have an earned income, you can contribute to a Roth IRA.

5. Is it better to invest in a Roth IRA or a 401k account?

There is no simple answer to this, and the right option would depend on your needs and goals. A Roth IRA can offer better investment options and can be used by people who do not have an employer plan like the 401(k), as well as people who already have a 401(k) and want to contribute more money. On the other hand, the annual contributions of a 401(k) are higher than a Roth IRA, so this can help you save more for your golden years. 401(k)s also have mandatory RMDs, whereas a Roth IRA has no such rules. Make sure to consider all pros and cons before taking a pick.

6. How much money should I put in my Roth IRA monthly?

You can contribute according to your goals, income, and budget. However, it would help you to save more money if you maximize your contributions and meet the prevailing limits.

7. What is the best place to start a Roth IRA?

You can start a Roth IRA at a bank, a credit union, or with an online broker. Several investment companies also offer a Roth IRA. A bank or a credit union would offer investments like a certificate of deposit or a money market account. Investment companies and online brokers, on the other hand, offer high yield investments like stocks, mutual funds, etc. so, you can choose between these options as per your risk appetite.

8. Can I open a Roth IRA at my bank?

Yes, you can open a Roth IRA at your bank.

9. Can you open a Roth IRA without a job?

Yes, you can open a Roth IRA without a job, as long as you have other earned income. This can include your spouse’s income.

10. Should I open a Roth IRA at a credit union?

Yes, you can open a Roth IRA at a credit union if you wish to. Credit unions can offer lower fees and help you cut costs. However, they also offer low-yielding investment options that can restrict your future earnings.

11. At what age should you start a Roth IRA?

You can open a Roth IRA at any age as long as you are an adult and have an earned income. In the case of minors, you can open a Roth IRA for kids below 18, but they would need a parent or guardian to open it for them.

12. Do I have to report my Roth IRA on my tax return?

Since your contributions are not deductible, you do not have to report them on your tax returns.

13. What is the 5 year rule for Roth IRA?

Individuals over the age of 59.5, who have held the account for at least five years, can take Roth IRA distributions without paying any federal taxes.

14. Do I make too much for a Roth IRA?

There are income limits to contribute to a Roth IRA. Only single tax filers earning a modified adjusted gross income (MAGI) of $140,000 or less are eligible. For married taxpayers filing jointly, your joint MAGI must be below $208,000 in 2021.

15. Can I have multiple Roth IRAs?

There is no limit on the number of IRAs you can have. However, you can only contribute up to the total contribution limits. For 2021, you can contribute up to $6,000 annually and $7,000 if you are 50 or older.

16. How do I avoid taxes on a Roth IRA conversion?

You will have to pay taxes on the previous contributions and your account’s earnings when you convert a traditional IRA to a Roth IRA. The only way to reduce this is through partial conversions over many years. But you cannot avoid taxes altogether.

17. Can my wife open a Roth IRA if she does not work?

Yes, you can use a spousal Roth IRA and contribute to your wife’s account from your earned income.

To conclude

A Roth IRA is a great retirement tool. It can reduce your taxability in retirement and is easy to set up. It can also be used to safeguard the future of other members of your family, such as your spouse or children. Moreover, by investing in high-yielding investment options, you can build considerable wealth over a period of time. However, you need to start investing from an early age to maximize your returns.

If you are wondering how to open a Roth IRA or which investments to choose, you can get in touch with a professional financial advisor in your area and get started. Use the free advisor match tool, answer a few simple questions about yourself, and get matched with 1-3 financial advisors that help you with your retirement.

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