What is a Roth IRA?
A Roth IRA is an individual retirement account that works by accepting after-tax dollars for contributions while giving tax-free growth and withdrawals during retirement. The main benefit of qualified Roth IRA accounts is all portfolio gains and withdrawals are tax-free.
It is called a Roth IRA after Senator William Roth, a Republican from Delaware, who championed the creation of this new type of retirement account. The Roth IRA was developed with the passage of the Taxpayer Relief Act of 1997. This legislation was made to provide an alternative to Traditional IRAs.
A self-directed Roth IRA is a type of Roth IRA that allows individuals to invest in a broader range of alternative assets such as real estate, private equity, precious metals, tax lien certificates, promissory notes, crowdfunding, limited partnerships, and limited liability companies.
A gold Roth IRA or precious metals Roth IRA is a type of self-directed Roth IRA that allows investors to hold physical gold (and other eligible precious metals) within their retirement account. It’s a gold IRA with tax-free gains and withdrawals.
A backdoor Roth IRA is a strategy used by individuals to contribute to a Roth IRA indirectly by first contributing to a traditional IRA and then converting the traditional IRA to a Roth IRA. This strategy is employed when the individual’s income exceeds the IRS limits for direct contributions to a Roth IRA.
A spousal Roth IRA is a Roth IRA set up for a non-working or low-income-earning spouse. It works by allowing the working spouse to contribute from their earned income to the spouse’s Roth IRA. This allows couples to save for retirement even if one spouse does not have earned income.
A Roth 401(k) is a type of employer-sponsored retirement plan that combines the features of a traditional 401(k) plan and a Roth IRA. In a Roth 401k, employees contribute after-tax dollars to the plan, which employers sometimes match. Growth and withdrawals are tax-free.
Roth IRA Equivalent in Other Countries
The Roth IRA in Canada is a Tax-Free Savings Account (TFSA). The TFSA is a registered investment account where contributions are made with after-tax dollars, and both investment growth and withdrawals are tax-free.
The Roth IRA in the UK is the Stocks and Shares Individual Savings Account (ISA). An ISA allows UK residents to save and invest money while minimizing taxes on interest, dividends, and capital gains.
The closest Roth IRA equivalent in Australia is a Self-Managed Superannuation fund. Superannuation is a government-supported, tax-advantaged retirement savings program. While Superannuation is closer to a 401(k) in the United States, the SMSF allows individuals greater control over their investment choices, similar to a self-directed Roth IRA. There are also options for favorable taxes on Roth IRA contributions as well as tax free withdrawal.
Roth IRA Advantages and Disadvantages
Advantages
Tax-Free gains. The account grows tax-free.
Tax-free withdrawals. When the account is at least 5 years old and the owner is 59 ½ years, withdrawals are tax-free.
No Required Minimum Distributions. The owner is not forced to withdraw from the account if not needed. It can keep growing.
Disadvantages
•No tax deductions while contributing to the plan. Roth contributions cannot be deducted from taxable income.
There’s a limit to contributions. Investor cannot contribute more when they exceed the limits.
What are the Differences between Roth IRA vs Traditional IRA?
| Roth IRA | Traditional IRA |
|---|---|---|
Taxation of contributions | Contributions are made with after-tax dollars. No tax deductions from contributions on the current year. | Contributions are made with pre-tax dollars. You can deduct the contributions from your taxable income in the year you make the contribution, reducing your taxable income for that year. |
Taxation of withdrawals | Withdrawals are tax-free and penalty-free after age 59 ½. No income tax on the earnings when you take the money out during retirement. | No penalties after age 59 ½ but withdrawals are taxed as ordinary income. Income tax is paid on both the contributions and the earnings when you take the money out. |
Income limit | There are income limits for contributing to a Roth IRA, which is adjusted annually for inflation. If your income exceeds the limits, you cannot directly contribute to a Roth IRA. | There are no income limits for contributing to a Traditional IRA, but there are limits on how much you can deduct from your taxable income based on your income and whether you or your spouse have access to a workplace retirement plan. |
Required minimum distributions (RMDs) | There are no RMDs during the account owner's lifetime. | RMDs start at age 72 |
What are the Differences between Roth IRA vs 401(k)?
| Roth IRA | 401(k) |
|---|---|---|
Plan Sponsor | Individual | Employer |
Contributions | Funded with after-tax dollars. The annual contribution limit is $6,500 per year ($7,500 if age 50 or older) in 2023. | Funded through pre-tax salary deferrals. In some cases, employers may offer a Roth 401(k) option, which allows for after-tax contributions. The annual contribution limit is $22,500 per year ($30,000 if age 50 or older). |
Employer Contributions | None | Employers may choose to match employee contributions up to a percentage of the employee's salary. The percentage varies across plans. |
Withdrawal Rules | Qualified withdrawals are tax-free. Withdrawals of earnings before age 59½ and before the account has been open for at least five years are subject to taxes and penalties. | Withdrawals are generally taxed as ordinary income. Both contributions and earnings are taxed upon withdrawal. With a Roth 401(k), qualified withdrawals are tax-free. Early withdrawals (before age 59½) are subject to taxes and a 10% penalty. |
Income limits | To contribute to a Roth IRA in 2023, income must be less than $153,000 for single tax filers and $228,000 for married and filing jointly. | There are no income limits for contributing to a 401(k). |
Investment Option | You have a wide range of investment options usually stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Get a wider set of options with Self-directed Roth IRAs. | Enter your text here... |
Required minimum distributions (RMDs) | There are no RMDs during the account owner's lifetime. | RMDs start at age 72. |
Where and How to Open a Roth IRA
An investor can open a Roth IRA with most financial institutions like banks and brokerages who will be called the account custodian. For more specialized investments like a gold Roth IRA, you need to work with gold IRA companies.
You can open a Roth IRA in 3 simple steps.
#1. Check Roth IRA Eligibility and Requirements
Anyone who has earned income, a social security number, and not too much income can open a Roth IRA. Earned income can be a salary from an employer or your own business.
To determine if your income allows you to open a Roth IRA, you need to find out your Modified Adjusted Gross Income (MAGI). The MAGI is also used to determine if you can deduct your traditional IRA contributions, your eligibility for premium tax credits, and your eligibility for healthcare waivers and incentives under the Affordable Care Act.
A financial advisor can help you compute your MAGI. You can also find the math to compute your MAGI on line 11 of IRS Form 1040, the US individual income tax return. Once you have your MAGI, check the table below, if you are eligible to contribute to a Roth IRA.
Tax Filing Status | MAGI 2023 | Contribution Limit |
|---|---|---|
Married filing jointly | Less than $218,000 | Full Limit |
Between $218,000 and $228,000 | Reduced amount | |
|
More than $228,000 |
Zero | |
Single, Head of Household, or Married filing separately and not living with spouse |
Less than $138,000 |
Full Limit |
|
Between $138,000 and $153,000 |
Reduced Amount | |
|
More than $153,000 |
Zero |
#2. Open Your Roth IRA
Open your Roth IRA with your preferred financial institution. Just fill up the required forms. You will need to provide identification and your Social Security Number. You can open a Roth IRA with even less than $100. Many brokerages don’t have an account opening minimum. However, your choice of investment, like some mutual funds, may have a minimum requirement.
#3. Choose Your Investments
Once you placed your initial Roth IRA contribution, you can choose your investments from the options provided by your account custodian. There are many allowable investments in a Roth IRA. You can choose from a wide variety such as stocks, bonds, mutual funds and ETFs. If you opened a self-directed Roth IRA, you have an even wider variety of options such as real estate, precious metals, private equity, and more.
Contributing to Roth IRA (Contribution Limits and Deadlines)
The annual Roth contribution limits for Roth IRAs are determined by the IRS and may change periodically. As of 2023, the annual limit is $6,500, or $7,500 for individuals aged 50 and older. The deadline for annual contributions usually coincides with the federal income tax filing deadline in mid-April.
Roth IRA Withdrawal and Distribution
A qualified withdrawal from a Roth IRA is tax-free and penalty-free if the account holder is at least 59 ½ years old and the Roth IRA account has been open for at least five years. Otherwise, it is subject to taxes and penalties.
Roth IRAs have no required minimum distributions (RMDs) during the account owner's lifetime.
What is a Roth IRA Conversion?
A Roth IRA conversion is the process of transferring funds using an IRA rollover from a Traditional IRA to a Roth IRA. This is usually done if an individual is no longer qualified to contribute to a Roth IRA because of their income or if they have already contributed the annual limit but they want to put in more money. Convert a Traditional IRA into a Roth IRA using an indirect or direct rollover.
There is no limit when doing a Roth IRA conversion. However, the account owner needs to pay taxes on the amount converted. Converting too much may lead to a significant tax bill.
A backdoor Roth IRA is a strategy that allows high-income earners, who are otherwise ineligible for direct Roth IRA contributions, to contribute to a Roth IRA by first contributing to a Traditional IRA and then converting the funds.
What is a Roth 401(k)?
A Roth 401(k) is a type of employer-sponsored retirement plan that combines the features of a traditional 401(k) plan and a Roth IRA. Like a traditional 401(k), a Roth 401(k) allows employees to contribute a portion of their salary to the plan, which is then invested on a tax-deferred basis. The main difference between a Roth 401(k) and a traditional 401(k) lies in the tax treatment of contributions and withdrawals.
- After-Tax Contributions: Roth 401(k) contributions are made with after-tax dollars. You pay taxes on the contributions upfront, but qualified withdrawals in retirement are tax-free.
- Tax-Free Withdrawals: Qualified withdrawals from a Roth 401(k) are tax-free, provided the withdrawal must occur at least five years after the first Roth 401(k) contribution and the account holder must be at least 59½ years old, disabled, or deceased.
- Employer Matching: Employers can choose to match employee contributions to a Roth 401(k), just as they can with a traditional 401(k). However, employer matching contributions are made on a pre-tax basis and are deposited into a separate account within the traditional 401(k) portion of the plan. Withdrawals from the employer match portion will be charged with normal income tax rate as ordinary income in retirement.
- Contribution Limits: The combined contribution limits for traditional and Roth 401(k) accounts are the same. For 2023, the limit was $22,500 for individuals under 50, and $30,000 for those 50 and older (including catch-up contributions). These limits are subject to change in future years.
- Required Minimum Distribution (RMD): Roth 401(k) plans are subject to RMDs, which means you must begin taking minimum withdrawals from your account starting at age 72 (or 70½ if you turned 70½ before January 1, 2020). However, you can avoid RMDs by rolling over your Roth 401(k) to a Roth IRA, which does not have RMD requirements.
Conclusion
A Roth IRA is one of many retirement savings options that give unique tax advantages. You contribute with after-tax dollars but you will enjoy tax-free growth and withdrawals. Understanding the ins and outs of Roth IRAs can help you make better decisions about your retirement planning.