Two of the greatest financial mistakes made by high earners and the middle class alike include failing to save enough for retirement and failing to take full advantage of tax-sheltered accounts. Fortunately, one solution can help with both problems: the Roth IRA.
Named after the late United States senator William Victor Roth Jr., who sponsored the bill that created this account, Roth IRAs combine flexibility with tax savings. The catch? You don’t see those tax savings now, but rather after you retire.
As you plan your retirement investments, make sure you understand the Roth IRA, because it forms a core option in your investing toolkit.
What Is a Roth IRA?
A Roth IRA is a type of individual retirement account (IRA). It allows you to set aside a certain amount of money each year for retirement, with special tax treatment.
Unlike with traditional IRAs that let you deduct the contribution from this year’s taxable income — lowering your taxes immediately — you still pay taxes on the money you contribute to a Roth IRA. But your contribution then grows tax-free, and you pay no income taxes on money you withdraw from the account in retirement. That lowers your tax bill in retirement, which in turn reduces the amount you need to save for retirement.
You can open and manage both traditional IRAs and Roth IRAs through a regular free brokerage like M1 Finance or TD Ameritrade. Which means you maintain full control over your investments, and can invest in any paper assets — stocks, bonds, exchange-traded funds (ETFs), commodity funds, and so forth — allowed by your brokerage.
It also means you completely own and control the account, unlike employer-sponsored retirement accounts like 401(k)s. You don’t have to change Roth IRA accounts each time you change jobs — you can keep the same account for your entire life.
Pro tip: If you’re investing in a Roth IRA (or any other retirement account), make sure you sign up for a free portfolio analysis from Blooom. They will make sure your portfolio is properly diversified and has the correct asset allocation. They’ll also check to see that you’re not paying too much in fees.
How Does a Roth IRA Work?
You open a Roth IRA account through your regular investment brokerage. Check out a list of the best places to open an IRA if you don’t have one already.
Once opened, you simply transfer money from your checking account to your Roth IRA, just like you would with a traditional IRA or taxable brokerage account. You can then buy and sell securities like stocks, bonds, mutual funds, ETFs, and real estate investment trusts (REITs) in your Roth IRA, again like a normal brokerage account.
You can only contribute up to the legal limit each year (more on that shortly), and you can withdraw your contributions at any time, since you already paid taxes on them. However, you can’t withdraw your gains (earnings) in the account until at least age 59 ½ without IRS penalties.
In retirement, you collect tax-free income from your Roth IRA to cover your living expenses. Easy peasy.
Roth IRA Restrictions
Not everyone can contribute to a Roth IRA and enjoy the tax benefits. Even those who qualify to contribute can’t simply dump as much money as they want into Roth IRAs.
As you plan your contributions, keep the following restrictions in mind.
To begin with, you can’t contribute more to an IRA than your reported earnings. If you report earnings of $3,000 for the year, you can’t contribute $4,000. This rule comes with one exception however: non-working spouses can still contribute to a spousal IRA if their spouse works.
The annual contribution limit to IRAs — both traditional and Roth — is $6,000 in tax year 2021. Older adults age 50 and above can contribute an extra $1,000 on top of that as a “catch-up contribution.”
Note that Roth IRA contribution limits apply as a combined limit for both traditional and Roth accounts. You can contribute to both IRA types in a single year, but the combined total can’t exceed $6,000 (or $7,000 at age 50 and above).
In 2021, single taxpayers can contribute the full amount to a Roth IRA if they earn a modified adjusted gross income (MAGI) up to $125,000. Above that, the ability to contribute starts phasing out, until disappearing entirely at a MAGI of $140,000.
Married couples filing jointly can contribute the full amount if they earn a MAGI up to $198,000. Between $198,000 and $208,000, the option phases out, and couples earning a MAGI over $208,000 can’t contribute at all.
Each spouse can contribute the full individual contribution amount, assuming their income falls below $198,000, for a combined contribution of $12,000 total for spouses under 50.
Roth IRA Withdrawal Rules
Roth IRA holders can withdraw contributions any time, penalty-free. If you’ve contributed $6,000 to your Roth IRA and your investments have grown — say to $10,000 — you can withdraw your $6,000 contributions whenever you want. But what about the earnings — the gains you’ve made from your investments inside the account?
Here, the IRS differentiates between “qualified” and “nonqualified” distributions. Qualified distributions are tax- and penalty-free, and require that your contributions have seasoned in your Roth IRA for at least five years. Beyond that five-year requirement, you must meet one of the following conditions for distributions to count as qualified:
- You are over age 59 ½.
- You have a permanent disability.
- You are using the money (up to $10,000) toward a down payment on your first home.
- You are deceased and the Roth IRA is being distributed by your estate.
If you pull earnings out of your Roth IRA before the contribution has seasoned for five years, and without meeting at least one of the requirements above, the IRS slaps you with a tax bill on the withdrawn amount, plus a 10% penalty.
Advantages of a Roth IRA
Roth IRAs come with a wide range of benefits, some of which might surprise you.
Keep the following in mind as you plan your approach to retirement investing through tax-sheltered accounts, because Roth IRAs should play a role in everyone’s retirement strategy.
- Tax-Free Withdrawals. You pay income taxes on contributions now, but you don’t have to pay taxes on gains or withdrawals in retirement. That prevents your taxes from going up in retirement, a greater risk than many Americans realize. It also reduces how much you need to save for retirement, since Uncle Sam won’t take a bite out of your withdrawals.
- Tax-Free Compounding. Over decades, compounding adds up to huge sums. If you set aside $500 per month for 30 years and earned an average historical stock market return of 10%, you’d have contributed $180,000 — but your ending balance would be $986,964. The $806,964 you earned in compounded returns would be tax-free in a Roth IRA.
- No Required Minimum Distributions (RMDs). The IRS requires you to start taking required minimum distributions or RMDs from your traditional IRA by age 72, so they can tax the income. But because you’ve already paid income taxes on your contributions to a Roth IRA, the IRS doesn’t care if you never withdraw the money, and doesn’t force you to do so with RMDs.
- No Age Limit to Open or Contribute. Teenagers under 18 can open a Roth IRA, as long as they have taxable income. And you can keep contributing until the day you die if you like, with no upper age limit.
- No Early Withdrawal Penalties on Qualified Distributions. You can withdraw contributions from your Roth IRA at any time, even before age 59 ½. After all, you’ve already paid your income taxes on those contributions. That removes the “fear of commitment” — if you end up needing the money for another purpose, such as buying a home or starting a business, you can pull it back out penalty-free.
- Compatibility With Other Accounts. Even if you have an employer-sponsored retirement plan such as a SIMPLE IRA, 401(k), or 403(b), you can still contribute to a Roth IRA as long as your income doesn’t exceed the limit. So you can still take full advantage of employer matching contributions, while also investing through your own Roth IRA.
- Full Control and Ownership. Most 401(k)s offer a handful of available investments, usually a few dozen at most. Compare that with the nearly limitless investment options available through an IRA account through your broker. And when you leave a job, you typically rollover the funds from your employer-sponsored account to either your IRA or to a new employer’s retirement account, or risk forgetting about it by the time you retire.
- Bankruptcy and Asset Protection. Retirement accounts, including Roth IRAs, remain immune from most creditors. And if you declare bankruptcy, most creditors can’t empty your retirement accounts to pay outstanding balances. One notable exception: the IRS. If you owe back taxes, expect no quarter or protections.
- Double Tax Protection With the Saver’s Credit. Those with modest paychecks can qualify for the Saver’s Credit, which — as a tax credit rather than a tax deduction — comes straight off your tax bill. If you meet the requirements and contribute to a retirement plan such as a Roth IRA, you can qualify for a tax credit up to $1,000 (up to $2,000 for married couples filing jointly).
- Estate Planning Perks. After the SECURE Act of 2019, heirs who inherit a traditional IRA must empty it within 10 years (known as the “drain-in-10 rule”). That rule doesn’t apply to Roth IRAs: your beneficiaries can opt to take a lump-sum payout tax-free, or they can spread out tax-free distributions over the rest of their lives, following the life expectancy method (read more about inherited IRA rules at Schwab if you want the gritty details).
- Conversions and Backdoor Contributions. You can transfer funds from your traditional IRA to your Roth IRA at any time. You do have to bite the bullet and pay income taxes on those funds now, but your money compounds tax-free moving forward. High earners can use this strategy to contribute money to a traditional IRA, then do a Roth IRA conversion to move the money into their Roth IRA despite earning more than the IRS allows.
Disadvantages of a Roth IRA
Roth IRAs aren’t a silver bullet. Make sure you understand the ramifications before pouring money into your Roth IRA.
- Income Restrictions. High earners can’t contribute to a Roth IRA. That said, they can use a backdoor Roth conversion. They get complicated fast though, so speak with a tax advisor before attempting this at home.
- Contributions Aren’t Tax-Deductible. You pay income taxes on your Roth IRA contributions this year, rather than getting the immediate tax deduction from traditional IRA contributions.
- Early Withdrawal Penalties on Nonqualified Distributions. While more flexible than most retirement accounts, Roth IRAs do restrict your access to your own money. Be careful to leave yourself enough of an emergency fund to avoid raiding your Roth IRA piggy bank.
For middle income earners, Roth IRAs offer a fantastic way to invest your retirement savings and lower your taxes later on. These accounts are flexible, allow returns to compound tax-free, and let you set aside wealth for your children both in their own Roth IRA and by bequesting your tax-free account to them.
Consider Roth IRAs an essential financial planning tool in your kit, and when in doubt, speak with a financial professional to get personal help and advice.