The Individual Retirement Account wherein you put your after-tax dollars is known as the Roth IRA account. Even though there are no present-year tax benefits, your earnings and contributions grow tax-free, and you can withdraw them penalty-free after you turn 59 ½ or once the account has been open for five years. Typically, the Roth IRA is an incredible savings option for people who aspire to be in the high tax bracket. It is essential to know that not everyone can open this kind of retirement account as there are income limitations applicable on opening a Roth IRA.
Read on to know more.
Funding of Roth IRA
The Roth IRA account can be funded via the following sources:
- Rollover contributions
- Spousal IRA contributions
- Regular contributions
Regular IRA contributions have to be made strictly in cash or checks. These contributions cannot be in the form of assets or securities. However, many investment options, such as stocks, mutual funds, CDs, ETFs, money market funds, and bonds, exist within the Roth IRA after these funds have been contributed.
Pros and cons of Roth IRA
Roth IRA has its share of pros and cons. Knowledge of both will help you make a wiser decision.
- You pay taxes upfront
Under Roth IRA, you get tax-free withdrawals in the future. However, if you are already in a fix with your savings, getting a tax deduction now to contribute to the traditional IRA can be quite the motivation for you to get your savings on track.
- The maximum contribution is not high
As of 2021, the upper cap on the Roth IRA contribution is $6000. This limit is $7000 for people who are 50 years or older. Even the limitations of traditional IRAs are the same. This will not suffice. Hence, you need to invest elsewhere, too, for instance, in 401(k). The two will ensure you have adequate money for your retirement. In 401 (k), the maximum allowed contribution limit for 2021 is $19500, and for people aged 50 or older, this limit is $26000.
- You will have to set it up on your own
When it comes to 401 (k), your employer will motivate you to put funds in it. In some cases, they will auto-enroll you. However, the same is not the case with Roth IRA. In this case, you will have to open your own Roth IRA account and continually remind yourself to put money in it every year. To make this process seamless, you can set up auto-debits.
- There is an income limit
Further, people who fall under the specific income bracket can only make contributions to Roth IRA. However, there is no capping on converting a traditional IRA to a Roth IRA.
Irrespective of the above-listed cons, Roth IRA, is indeed one of the best ways to save for your retirement. Here are some pros associated with it.
- Your savings will increase tax-free
By paying tax upfront, your earnings will grow tax-free. In addition, it implies that after you reach your retirement age, you will not have to pay any tax on your withdrawals. Consequently, your savings will be relatively higher, specifically if you are in the higher tax bracket during your retirement.
- No requirement for mandatory minimum distribution
In traditional IRAs, you have to withdraw the money as soon as you reach 72. However, the same is not the case with Roth IRA. You can contribute at any age if you meet the eligibility criteria.
- Your contributions can be withdrawn
In contrast to almost every other retirement account, in Roth IRA, your contributions are easy to withdraw. Moreover, you can withdraw your contribution at any time, sans any penalties. Hence, Roth IRA is indeed one of the best backup emergency funds. However, please know that it is your retirement fund, so do not abuse it.
- There is tax diversification in retirement
When you have a traditional IRA or 401 (k), you will be paying the tax on the money as and when you begin withdrawing the same in retirement. Moreover, you will be paying the tax on the Social Security income as well. Hence, when a portion of your money is in a Roth IRA, you have flexibility. It implies that you can move your contributions from other accounts, ensuring that you do not sway yourself into a high tax bracket. So, what you can do is get your Social Security, following which, you can take some amount from the traditional IRA or 401 (k). This will just adequately bump you up against the edge of the income tax bracket. If there is a requirement for a higher income, you can withdraw the same from your Roth IRA. It will not count as taxable income.
- No income tax on inherited Roth IRAs
If you pass your Roth IRA to your heirs, the withdrawals they make will also be tax-exempted.
How to open a Roth IRA?
Your Roth IRA must be established with an institution that is IRS approved to provide you with IRAs. These include institutions, such as brokerage companies, banks, savings and loan associations, and federally insured credit unions. In most cases, individuals prefer to open IRAs with brokers.
You can start a Roth IRA at any time, but you need to make contributions for a tax year ahead of the tax-filing deadline. This date is April 15th of the following year. Herein, extensions on tax-filing dates do not apply.
When a Roth IRA is established, there are two key documents to be furnished by the IRA owner. These include:
- The IRA disclosure statement
- The IRA adoption agreement and plan document
These explain the rules and regulations under which the Roth IRA will function. Further, the documents establish an agreement between the IRA trustee or custodian and the IRA owner.
Not every financial institution is the same. Some of them will have a detailed list of available investment options. On the other hand, others may be confining. Typically, every institution has a different Roth IRA fee structure. So naturally, this will directly influence your return on investment.
Moreover, the investment preferences and the risk tolerance will also play a crucial role in selecting a Roth IRA provider. If you intend to be an active investor and make plenty of trades, you should look for a Roth provider with a minimum trading fee. Some providers will even charge you if your account has been inactive for a bit, while others will levy a fee if you do not do anything with your investments for a while. Some providers offer more diverse exchange-traded fund or stock offerings compared to others. Broadly, all of this depends on the kind of investment you need in your account.
Regardless, you must be careful with specific account requirements, too. Some providers have a high minimum account balance compared to others. So, if you wish to bank with the same institution, you must inquire about their other banking products. You can even speak to any existing customer and learn about the perks they are receiving, such as an IRA fee discount.
Who can open a Roth IRA account?
Generally speaking, anyone can open a Roth IRA account. However, they need to meet the following qualifications.
- You should be under the income limit
As of 2021, to make Roth IRA contributions, your modified adjusted gross income for single filers should be $140,000. The same for married filers filing together should be $208,000. However, with the Backdoor Roth strategy, you get a workaround for these limits.
- You must have an earned income
For opening a Roth IRA account, you should have earned income from work or taxable compensation. Also, the maximum contributions to the Roth IRA account can be income from work or $6000, whichever is less. As stated above, for people 50 or older, this limit is $7000.
Can you have more than one IRA?
At times, you may have more than one IRA, and this could be for the following reasons.
- You already had one Roth IRA account, but then you rolled an old 401 (k) into a traditional IRA account.
- You inherited an IRA, but you had one of your own already.
- Your adjusted gross income surged to the extent where you were no longer qualified to add more money to your Roth IRA account. So, you opened an account for a traditional IRA.
- You have your Roth IRA account, but you opened a traditional IRA to get extra tax deductions.
As per law, you can contribute to as many IRAs as you like. However, there is an upper cap on the maximum amount you can deposit to all these IRAs combined in a year. This contribution, as stated above, is not high and is only $6000 for people below 50 and $7000 for 50 and older.
So, if Tom, 36, makes a contribution of $3000 in the traditional IRA account in 2021, the maximum contribution he can make to his Roth IRA account in 2021 will be $3000.
What is a Spousal Roth IRA account?
The Roth IRA for spouses allows you to be a Roth IRA Millionaire quicker and more easily. The good thing about Spousal Roth IRA is that couples, wherein only one partner works too, can open a spousal Roth IRA account. So, regardless of whether your wife or husband is in-between jobs or a stay-at-home spouse, you can make spousal Roth IRA contributions. In this case, you will be making contributions as a household. So, you can contribute, even to your unemployed spouse. However, there is an assumption that you qualify for the contributions as per the stipulated income limits.
What are Roth IRA withdrawal Rules?
Here are some distribution and withdrawal rules associated with Roth IRA.
- You are free to withdraw your initial contribution as and when you like, sans any taxes or penalties, regardless of how long your account has been open. It is because the money in your Roth IRA account is the money on which income tax has already been paid.
- Upon withdrawing the money from the Roth IRA, IRS will automatically assume that your original contribution will come out first.
- The qualified withdrawals of returns in earnings will be tax-free. But, in some instances, the IRS might demand a share of these returns. It might either be in the form of a penalty or taxes when you do not adhere to the rules of the qualified withdrawal or withdraw early.
- If you are 59 ½ or older and have held a Roth IRA account for five years or more, you can take the distributions and the earnings, sans any implication of federal taxes.
Are Roth IRAs Insured?
When your Roth IRA account is located at a bank, you must know that the Roth IRAs will not be under the same category as the conventional deposit accounts. They are a completely different insurance category. Hence the IRA account coverage is not that solid. But the Federal Deposit Insurance Corporation (FDIC) offers insurance protection of up to $250,000 for both Roth IRA and traditional IRA accounts. However, the balances are clubbed together and not viewed individually.
For instance, the banking customer has a Certificate of Deposit held in their traditional IRA amounting to $50,000, along with a Roth IRA in the savings accounts, amounting to $250,000 with the same institution. In this case, the bank will consider the vulnerable assets of the account holder, sans any FDIC coverage, to be $50000.