The Roth IRA: What It Is and How It Works
A Roth IRA is a type of retirement plan and investment account that allows you to withdraw money tax-free from your retirement account under certain conditions. However, unlike a traditional IRA, the Roth IRA account does not give you tax-free contributions on the front end. You reap the tax benefits at retirement age instead.
While there are other major types of retirement plans such as the previously mentioned traditional IRA, the traditional or Roth 401(k) plans and the 403(b) plan, the Roth IRA remains a popular option.
In this article, we will explain further what a Roth IRA is, how it works and how you benefit from contributing to one. By the end of this article, you will know how these accounts can help you with your retirement planning.
What Is a Roth IRA?
A Roth IRA is an investment account that you can use to help prepare your finances for retirement. IRA stands for “Individual Retirement Account” – which is exactly what this investment vehicle is.
This type of account was created in 1997 by the Taxpayer Relief Act of 1997, whose chief sponsor was the account’s namesake, Senator William Roth. It was designed to help provide tax relief in retirement planning to people who stand to benefit.
Like a traditional IRA, you can make a number of annual contributions to these accounts each year up to a certain limit set annually by the IRS. However, in this case, the contributions are not tax-deductible. This means there’s no immediate tax benefit to gain.
Instead, the benefit comes later on when you are ready to take your withdrawals during retirement. Generally, when you withdraw your contributions and investment gains, they will be tax-free.
A Roth IRA makes a lot of sense if you expect to have a higher tax rate in your retirement years than you do now. That’s because you pay your taxes now, when you presumably have a lower tax rate, and reap larger benefits later.
How Much Can I Contribute?
The amount you can contribute to a Roth IRA varies each year. The contribution limits are set by the IRS. In 2020, you are allowed to contribute $6,000 in sum to all of your IRAs including a Roth or traditional.
However, if you are age 50 or older, you can contribute an additional $1,000 “catch-up contribution” to further pad your retirement investments.
The contribution limits for 2021 are being held steady at $6,000 total, or $7,000 if you are old enough to qualify for the catch-up contribution.
The contributions are not tax-deductible, but once you contribute they can grow tax-deferred and can generally be withdrawn tax-free in retirement.
One important thing to note, however: Contributions to your Roth IRA must remain in the account for at least five years to be withdrawn tax-free. Otherwise, they will earn you tax consequences upon withdrawal.
When Can I Withdraw From My Roth IRA?
Technically, you can withdraw from your Roth IRA anytime. However, depending on when and how you do so, you will face no taxes, some taxes or even an additional tax penalty.
In general, the owner of the account may not withdraw funds before age 59 1/2 without facing a 10% tax penalty on his or her disbursement. Because this is a steep penalty, it is generally inadvisable to take early withdrawals. That being said, in a true financial crisis it may be worth doing.
The dividends, income and capital gains you earn on your investment are not taxed at the time they are realized. Generally, they can remain completely tax-free if you follow certain procedures.
After age 59 1/2, you may begin taking your withdrawals from the account. However, it may often be advisable to wait longer. By using our investment calculator – which I do almost daily – you can see how much more money you could earn by leaving it invested longer.
Other Features of Note
One great thing about the Roth IRA is that you can contribute at any age. The only requirement is that you earned income during that year. And you can hold on to the account indefinitely as there are no required minimum distributions (RMDs) – unlike a 401(k) or traditional IRA.
There are several different ways you can fund the account. These include regular contributions (that must be made in cash or checks), spousal IRA contributions, rollovers and conversions.
Once you fund the account, there are a variety of different investments that you can buy, including…
- Individual stocks
- Mutual funds or ETFs
- Money market funds
Of course, as with any investment, the riskier the asset class, the higher the returns you have the potential to reap. Particularly during your younger years, it’s usually good to fund your account largely with stocks, mutual funds or ETFs that invest in stocks. As you get closer to retirement, it often makes sense to shift into the less risky assets like corporate bonds or treasuries.
Traditional vs. Roth
So which is the better account to use for retirement: a traditional or a Roth IRA?
The truth is, everyone’s situation is different. In some instances, one makes more sense than the other. In other cases, you might benefit from both accounts together.
I checked in with The Oxford Club’s Chief Income Expert and Editor of Wealthy Retirement Marc Lichtenfeld on which account he preferred. Here are his thoughts:
The most attractive feature of a Roth IRA is that your withdrawals are tax-free – and who doesn’t love tax-free income? However, you’ve already paid taxes on the contributions. And if you’re deciding between contributing to a Roth versus a traditional IRA, remember that contributions to a traditional IRA can lower your taxable income and, as a result, your taxes in the year the contribution is made.
So it really depends upon your specific case and whether you’d rather pay taxes now or later. The difference between your current and retirement income tax rates makes a huge difference here.
Concluding Thoughts on the Roth IRA
For many people, a Roth IRA can be a great vehicle for saving for retirement. It can also be especially useful if you are aiming for early retirement like many in the FIRE movement.
The Roth IRA can and should be used in conjunction with other kinds of retirement plans like 401(k)s and taxable brokerage accounts to save for your retirement. Investing more is almost always better and you will very rarely regret it.
If you are interested in learning more about how to build a wealthy retirement, sign up for our free Wealthy Retirement e-letter with more great insights from Marc Lichtenfeld on how to invest in your Roth IRA and lots of other great investing ideas.
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.