What Is a Roth IRA Account? Definitive Guide to Retirement

Most people worry about their financial future after their retirement. Even if you are still young, you may well be looking ahead to the future and wondering what you can do to ensure that you and your family can live comfortably after your working life comes to an end. Making wise investment choices can be difficult, especially when there are more options now than ever before, in addition to economic uncertainty and an increased number of scams and dodgy investment schemes being peddled to prospective investors. 

You may have heard the term IRA before when reading or talking about investing for the future. IRA stands for Individual Retirement Account, and is exactly what it sounds like – an account for you to store funds in that you can access in your retirement. There are a few different types of IRA available to investors today. 

With a more traditional IRA or a 401(k), the opposite is true – you are likely to be able to take a tax deduction on contributions when you first pay those contributions into the account, but then have to pay tax on those contributions when you withdraw them.

Another way is to invest through a gold IRA by allocating some of your portfolio through a rollover.

You can read our review of GoldCo here. GoldCo is the top ranked company for precious metals rollovers in 2020.

Roth IRAs are used for a variety of reasons, the main one being that investors may expect their tax rates to be higher in the future when they retire and take withdrawals from their IRAs. Essentially, using a Roth IRA instead of a traditional IRA is a way of making a smaller sacrifice (paying income tax on your contributions upfront) for the long-term goal and benefit of not having to pay what is likely to be a significantly larger amount in tax in the future. This option is attractive to a lot of investors, particularly those who pay a low tax rate but anticipate moving up to higher tax brackets in the future.

Even if you don’t have an expectation of what your tax rate may be in the years or decades to come, a Roth IRA may well be a good choice. Investment options can be confusing and hard for even experienced investors to get their heads around the different options – that is why we have decided to provide here the definitive guide for your Roth IRA. Now that we have covered the basics, let’s go into some more detail. 

How Does a Roth IRA Work?

It is similar to a traditional IRA in the sense that it is an account for holding your investments. Roth IRAs can be opened at most banks or at a brokerage. Once you have opened the account, you can choose what kind of assets you would like to invest in – such as stocks, bonds, mutual funds, ETFs (exchange traded funds), or bank savings products. 

You will be given the choice with a Roth IRA to either contribute multiple smaller amounts over the course of each year, or to contribute in a single lump sum each year. The important thing to remember is that these contributions cannot exceed $6000 a year if you are below 50 years of age (or $7000 a year if you are older than 50), or the amount of your taxable compensation – whichever amount is less.

If you are aiming to save for a long term goal, such as retirement, bonds and stocks are widely recommended investment choices. This is because they provide higher returns on your investment over long periods of time than other assets do. If you choose to invest in stocks and / or bonds, you will need to open your account at a brokerage or a robo-advisor, not at a bank!

Roth IRA Insurance

IRAs come under a slightly different insurance category than regular deposit accounts do if your account is with a bank. This means that insurance coverage for IRA accounts is less than that of more conventional savings accounts. 

However, this does not mean that no insurance coverage is available for your Roth IRA. The FDIC (Federal Deposit Insurance Corporation) does offer protection of up to $250,000 for Roth (as well as traditional) IRA accounts, although the account balances will be combined instead of taken individually. Sound confusing? Let’s go into an example.

If you, as a single customer, have a certificate of deposit held within a traditional IRA with funds totaling $150,000, and you also have a Roth IRA which is in a conventional savings account with a total value of $200,000, and both accounts are held with the same institution, you will have $100,000 worth of assets that will not be covered by the FDIC.

What Are the Benefits of Having a Roth IRA?

There are numerous benefits to having a Roth IRA! We have listed the most notable ones below for your information.

• Flexible Contributions: When you choose to contribute to your account, and how much money you choose to contribute each time, is up to you – as long as you do not try to contribute more than $6000 (if you are under 50) or $7000 (if you are age 50 or older) a year in total. If you wanted to contribute $5000 in one month and then only $100 every other month of the year, you could do that!

• Flexible Withdrawals: You can withdraw the money you contributed any time, without taxes or penalty. (You may be taxed or penalized if you withdraw investment earnings.)

• Works Alongside a 401(k): Even if you already have a 401(k), or are planning to potentially open one in the future, you can still open it without being penalized!  

• Tax Deadline: You can make contributions all the way up until the standard April tax deadline. 

• Early Access to Distributions: Once you have held your account for at least 5 years, and have hit age 59 ½, you can then start to withdraw distributions from your account without having to pay federal taxes on them! 

• Can Be Opened At Any Age: Whether you are a young graduate new to your career or a long-time member of the workforce, you can open it. It is never too late or too early – as long as you have earned income. You cannot contribute more than the amount your earned income, so you should have some earnings before you open the IRA.

• No Required Minimum Distributions: Unlike traditional IRAs and 401(k)s, a Roth IRA is not subject to any minimum required distributions from a certain age (at time of writing, this age is 72). This gives you more flexibility to access your investment funds when you want to!

Who Is Eligible For a Roth IRA?

To be eligible for a Roth IRA (or a traditional IRA), you must be in receipt of an income for your work. This income is given the term “taxable compensation” by the IRS (Internal Revenue Service). Again, the maximum annual contribution of $6000 / $7000 applies. 

The only downside to the Roth IRA is that high earners may not be eligible. Over certain thresholds of income, the amount that an investor can contribute will shrink by certain degrees. Over a certain limit, your ability to make contributions is completely eliminated. This limit is dependent on your MAGI (modified adjusted gross income) – your adjusted gross income with certain exclusions and deductions added. To learn more about this, and find instructions for calculating your modified adjusted gross income, check IRS Publication 590-A, Worksheet 2-1.

However, there is a workaround that allows higher earners to use the Roth IRA – we will go into detail on this below!

Backdoor Roth IRAs

One legitimate and completely legal way to sidestep the rules on income limits for Roth IRAs is to use what is known as a “Backdoor Roth IRA”. This is a popular strategy to make contributions into a Roth IRA even if you exceed the income limits.

With a Backdoor Roth IRA, you simply open a traditional IRA, and then convert that money into a Roth IRA.

The thing to consider about this strategy is that you may face a significant tax bill on the conversion, as the IRS will factor in any and all of your IRA accounts combined. For example, if your traditional IRA / IRAs total 60% pre-tax funds and 40% after-tax funds, the IRS will use a ratio to determine the percentage of the money that you convert into the Roth IRA that will still be taxable. In this case, 60% of the amount that you can convert will be taxable by the IRS, whatever amount you choose to convert. The IRS will apply this rule pro-rata to your total balance at the end of the year – not at the time you make the conversion!

Spousal Roth IRAs

There is another workaround to some of the eligibility rules for a Roth IRA. The rule that you must be working to open a Roth IRA contains an exception: if you are married and file your taxes jointly with your spouse, only one member of the couple needs to be actively working for payment. The non-working member can contribute to what is known as a “spousal IRA”, on the condition that the couple’s contributions combined don’t exceed the annual taxable compensation.

For example, if the working spouse’s taxable compensation comes to at least $12,000, that means that each spouse can only contribute a maximum of $6000 each. If the couple are both age 50 or older, and taxable compensation is $14000, then each spouse is able to contribute a total of $7000 each. The spousal IRA works like any other IRA – traditional or Roth – and is held in the name of the non-working spouse.

How to Open a Roth IRA

Opening a account is not a difficult process. Most banks, online brokers, and robo-advisors offer services.

You can operate a Roth IRA in different ways – if you want a more “hands-off” approach, where choices are made and the account looked after for you, you may want to use a robo-advisor with an automated investment process. If you would prefer to be more active and “hands-on”, with more work on your part but more control over the account, a traditional broker is probably the better option for you.

Robo-advisors such as Betterment and Wealthfront come recommended by many experts, and use algorithms to make investment choices and plans on your behalf, tailored to your specific requirements which are taken initially. The advantage of these is not ust convenience – they are also significantly cheaper than using a traditional broker.

However, traditional brokers can be even more accurate and profitable, especially when expert financial advisors are used. If you prefer the human touch, traditional brokers such as Merrill Edge, TD Ameritrade, and many more may be right for you.

Roth IRA Withdrawal Rules

The good thing about a Roth IRA is that you are able to withdraw any of your contributions at any point whenever you choose, without there being any penalties or taxes to pay, as you already paid the income tax before making the contributions! 

The only thing to remember is that the IRS will require income tax on any investment returns that you may earn on the money in your account – and there is also the potential of an early withdrawal penalty. There are some exceptions to these IRS rules, however, which make it possible for you to withdraw investment earnings without a penalty. You will need to check the IRS regulations if this is something that you are thinking of doing.

Is a Roth IRA or a Traditional IRA Right For Me?

The main thing to consider when trying to decide between opening a traditional or Roth IRA is whether you are looking for a long-term or a short-term investment. 

If, for example, you are a young person at the beginning of their working and investing life, a Roth IRA is likely to be a more profitable long-term choice as your income tax will most likely increase as you get older and progress through your career and higher tax brackets. Paying the income tax before making contributions to the IRA helps you avoid needing to pay back higher rates of tax on it when you make withdrawals for retirement.

Older people may be in the opposite situation, and be more interested in a more immediate tax break that a traditional individual retirement account provides. However, Roth IRAs can also be advantageous for older investors for different reasons. If you are a retiree with assets in various accounts such as 401(k)s and traditional IRAs, these can lead to tax bills. Taking a portion of these assets and putting them into a Roth IRA can prevent you from being placed into a higher tax bracket. Having tax-free income in a Roth IRA, alongside your other assets, is recommended by some financial advisors as an effective form of tax diversification.

How Much Does a Roth IRA Earn?

Another advantage of a Roth IRA is that (unlike regular bank savings accounts) it does not have a fixed interest rate – the money that you earn will be dependent on the assets that you choose to invest in! If you are a while away from retirement, it can be profitable to invest in stocks, because the average return from the stock market is generally higher than that from bonds and other less “risky” investment choices.

Can Roth IRAs Lose Money?

Your profits and potential losses will be dependent on which assets you invest in. Although the stock market has a higher average return than other investments, it does fluctuate more. However, retirement investors who stick to their stock investments over decades are most usually able to “ride out” any dips in value and end up with returns higher than most other assets. As with any investment plan, diversification is advised – and robo-advisors these days can even help you with these choices!

Summary

There is no perfect retirement plan that works for every single investor. However, the bottom line is that in most cases, traditional IRAs favor those looking for a more immediate tax break, whereas the Roth IRA is a better choice for younger investors and / or those looking for tax-free income after retirement. We hope that this definitive guide for your Roth IRA has been helpful to you!