What Is A Roth IRA?

By Jim Meindl

What is a Roth IRA?

It is an individual retirement account (IRA), in which the account holder has to contribute after-tax dollars. This allows a person to withdraw without paying taxes on certain conditions. This program, designed in 1997, is named after William Roth, who was a Delaware Senator.

Roth IRAs have quite the same features as a traditional IRA. The most significant difference between them is the method of taxation. In Roth IRAs, people need to contribute after-tax dollars. So, when you start withdrawing money, it will be tax-free. On the other hand, in a traditional IRA, a person needs to deposit pretax dollars. This way, a person will get a tax deduction on their contributions. They also have to pay income tax when they withdraw money from their account during retirement. Because of these reasons, Roth IRAs are the better choice for retirement savers.

Understanding Roth IRAs

Like some of the qualified retirement plan accounts, the money you invest in this account will grow tax-free. But Roth has lesser limitations than other similar accounts. You can continue your contributions at any age until you are earning income. Additionally, you can maintain the Roth indefinitely and don’t need to worry about required minimum distributions (RMDs), as you do in 401 (K) and traditional IRAs.

You can fund the Roth from the following sources.

Transfers
Regular contributions
Spousal IRA contributions
Rollover contributions
Conversions

Not to mention, all the regular Roth contributions should be in cash, which includes checks. You can’t contribute in the form of assets or securities. But there are several investment options for you in Roth IRAs once you contribute the funds, including bonds, stocks, mutual funds, CDs, ETFs, and money market funds. IRA also has restrictions on how much a person can deposit in an IRA. However, the contribution limitations are the same for both Roth and traditional IRAs.

How Does Roth IRA Make Money?

The Roth IRA is the best way to save your money by minimizing your taxes. You also need to understand that it doesn’t directly make money for you. This retirement account grows with the contribution of investment earning and your contributions. This way, the more you deposit to your Roth account, the more worthy it will be when you are not withdrawing funds from it.

Regularly contributing to your account is great, but don’t forget the annual contributions limit, which is $6,000 from 2020 to 2021 or $7,000 if your age is more than 50. Furthermore, Roth also has some income restrictions. This means people who have good earning will get lower contribution limits or can’t contribute money directly to a Roth account.

A person has to place their contributions in different investments whose values will increase over time and gives you interest or dividends, which they can withdraw tax-free. It is also great for people who can’t contribute actively to the Roth IRA. Moreover, this account growth can be worth thousands of dollars when you reach your retirement.

How much amount will get in your account significantly depends on how much you are willing to contribute and in what thing? Obviously, it’s impossible to predict how much you can get as the stock market is volatile, and past years can’t guarantee you promising results in the future.

What are the Options for Investment?

You can invest in different assets depending on the type of Roth IRA you have chosen. It also depends on your custodian. Most IRAs allow you to invest in the following fields.

Stocks – Investing in a stock means that you are buying some part of the ownership of the company. Stocks can give larger returns compared to bonds over the course of time. However, stocks can become volatile for a short period.

Bonds – Bonds are considered as debt. When you purchase a bond, you lend money to a government organization or company that will pay you back with interest over time. This type of contribution offers you lower returns compared to stocks but are more predictable.

Mutual Funds – These are baskets of bonds and stocks that you buy in a bundle. They help you to quickly expand without investing in a bunch of individual bonds and stocks.

Exchange-Traded Funds (ETFs) – ETFs are quite similar to mutual funds. But you need to trade them like stocks. Additionally, you can only buy mutual traded funds at the same price at the end of the trading day.

Certificates of Deposits (CDs) – This is a unique type of savings account that you can open in different banks. CDs require you to leave a good amount of funds in an account for many months or years to get a higher interest after some time.

Money Market Accounts – This is also a type of savings account that gives you more than the average rate of interest. Money market accounts also limit monthly withdrawals. Although, if you are investing in it through Roth IRA, you can withdraw money until your retirement.

So, these are the investment options. You are free to choose any of the mentioned ways to invest in a Roth IRA.

What Options You Don’t Have

Many IRAs don’t offer you investments in the following assets:

Precious metals
Real estate
LLC membership interest
Cryptocurrency

Although there is a way for those who want to open a self-directed IRA, this is a special type of Roth that allows you to invest in things that you can’t hold in your retirement account. Moreover, these accounts work best for experienced investors. However, they may feel it challenging to open one as only a few custodians offer them. There are also some assets that you can’t invest in whether you use a self-directed or Roth IRA. This includes collectibles such as stamps, artwork, and antiques.

Who is Eligible for Roth IRAs?

Not everyone is eligible to invest in Roth IRAs. There are proper criteria which you have to pass to participate in it. Here are the basic qualifications and rules.

Income from Work – A person needs to have income from their work. Additionally, the maximum amount you can deposit to a Roth account every year is your income from the job or $6,000. People of 50 age or more than that can contribute $7,000.

Lower Income – To open your account in the Roth, you need to be under the income limit. The funds you can contribute to your account starts getting low at specific thresholds for modified adjusted gross income. Not to mention, the amount keeps shrinking with the rise in income. You can check IRS Publication 590-A Worksheet 2-1 to get a complete structure of the limits.

Advantages and Disadvantages of Roth IRAs

Like other investment accounts, Roth IRAs have both benefits and loopholes, which not only make them distinctive from other investment methods but also increase their worth. Let’s discuss the pros and cons of Roth.

Advantages

Here are some benefits which force you to indulge in this investment method.

Tax Savings – If you think that your tax rate will go higher in recent years, Roth is ideal for you. Why? If you contribute money today, you will pay income taxes this year instead of paying taxes according to the future when your rate is higher. So, it makes sense; if your tax rates are lower now, it’s better to pay taxes now to get tax free retirement withdrawals.
Easy Withdrawal Method – Another advantage is that you are free to withdraw the money you have contributed at any time without paying penalties and taxes. But you may have to pay the penalty or tax if you withdraw investment earnings.
Double Investment – Roth IRAs allow you to contribute in a Roth as well as in a 401 (K).
Flexible Timing – The investor can choose how and when they want to contribute to their account. For instance, you can contribute $6,000 all at once or can split up the amount over many months.
Long Durations – You have enough time to contribute to your account. So you don’t need to worry. You can contribute until the tax deadline for the previous calendar year.
Tax-free distributions – Once you are 59 ½ and have this account for at least five years, you get the option to take distributions that include your earnings without paying federal taxes.
No Age Limit – There is no age limit. You can initiate investing at any age, as long as you are earning money from work. Don’t forget you can’t contribute more than your earnings.
No RMDs – These IRAs don’t ask for the minimum distributions, unlike traditional IRA or 401 (K) starting at age 72.

Disadvantages

While it’s a perfect investment area for many people, it does have some cons which you may want to know. Let’s discuss them.

Need to Pay Taxes Upfront – Roth IRA provides you tax-free withdrawals in the future. However, for those who are struggling to save money, contributing to Roth IRAs may not seem a good idea when a traditional IRA is a carrot, as you need to start working for your retirement savings.
Low Maximum Contribution – As we have already discussed, the Roth maximum contribution limit is $6,000 in 2020 and 2021 and $7,000 for people above 50. Traditional IRAs offer you the same contribution limits. But you also need to invest somewhere else, such as 401 (K), to save a good amount of funds for retirement. A 401(K) has a yearly contribution limit of $19,500 for 2020 and 2021 and $26,000 for people above 50.
Personal Adjusting – The distinct feature of 401 (K) is that your employer motivates you to join. But you need to open your Roth account by yourself and keep in mind that you need to contribute to it every year. However, if you set up automatic contributions, you can make it easier.
Income Limits – As discussed above, people who fall in the limited suggested incomes can contribute to Roth IRAs. But you don’t face an income limit issue when you convert your traditional IRA to a Roth.

How Can You Open A Roth Account?

You need to open your account at a bank or brokerage. Then you need to invest the money. It’s up to you what you want to invest in, such as stocks, mutual funds, bonds, EFTs, or bank saving products. If you are planning to invest in bonds and stocks, you may need to open your account at a Robo-advisor or brokerage instead of a bank.

Once you choose the option, you can contribute money at any time. You can go for paying a lump sum or contribute over the course of the year; all is fine unless you don’t exceed the $6,000 or $7,000 limit if you are 50 or taxable compensations. You also have the choice to add money to a Roth account by transferring your money from another retirement account.

Lastly, you may want to know how banks, Robo-advisor, and traditional brokers are different from each other.

Banks

As most banks offer savings vehicles, such as CDs, they are not the best place to open IRA instead of investments.

Robo-Advisors

A person who is looking for a hands-off approach in terms of investing, a Robo-advisor and their automated investment method may seem appealing to them.

Traditional Brokers

They offer you several active approaches while choosing your investments.

Bottom Line

In a nutshell, Roth IRA is the best retirement savings plan if you want to avoid future taxes, which can get higher over the years. It also allows you to withdraw money tax-free, which you don’t get from the other investment methods. Other benefits are that there is no age limit and time frame to invest.

However, it doesn’t have income-related limits that a person who earns a high income can contribute lower amounts. But still, it’s an ideal investment method for low salary earners worried about their future and increasing tax deductions in different saving accounts.

So, if you are thinking of contributing to a Roth, make sure that you have chosen the best option for investing as well as an ideal agent who can open your account and guide you well in it, whether it is a bank, traditional brokers, and Robo-advisor.

Engage with the entire King Financial Network team on www.kingfn.com to see what other expert advice we can provide towards your financial well-being.

Jim Meindl is a Wealth Management Associate at King Financial Network. His expertise is on Risk Management, Mutual Funds, and Exchange Traded Funds research and analysis.

King Financial Network is an integrated, team-based network that takes a comprehensive, customized, and independent approach to guide you through Financial, Retirement, Tax, Insurance, and Estate Planning.

Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser.

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