Roth IRA: How these retirement savings accounts work

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A Roth IRA is one of the most popular ways for individuals to save for retirement, and it offers some big tax advantages, including the ability to withdraw your money tax-free in retirement. In fact, many experts consider the Roth IRA the best retirement option available.

Here’s how the Roth IRA works, what it offers and how it compares to a traditional IRA.

If you already know you want a Roth IRA, it’s tremendously easy to open one and get started.

The Roth IRA offers big tax advantages

Like its cousin the traditional IRA, a Roth IRA offers individuals an opportunity to save for retirement on a tax-advantaged basis. You can deposit after-tax money into the account, grow that money and then take it out at retirement (age 59 1/2 or older) and never pay taxes on it. The whole “tax-free forever” part? That’s what turns heads, but the Roth IRA offers other perks.

Its tax-free nature makes the Roth IRA especially attractive if the account is likely to be passed down, since it can save the inheritors significant taxes. Plus, you’re never too old to invest in a Roth IRA, so you can stash money there your whole life, as long as you qualify (see below).

The Roth IRA is flexible. You can withdraw contributions any time tax-free (since you’ve already paid taxes on them). If you take out earnings early, though, you can be hit with taxes on the gains, though some uses, such as for qualified educational expenses, can help you avoid taxes. In addition to taxes on your gains, early withdrawal may lead to a 10 percent bonus penalty.

What are the other rules?

You can withdraw any contributions and earnings tax-free at retirement, with only one stipulation: five years must have elapsed since your first contribution to a Roth IRA, and the clock starts on January 1 of the year you made it. The five-year rule is important to remember, and it means that you need to open a Roth IRA earlier and plan a bit ahead.

In 2020, you’re allowed to contribute up to $6,000 annually to your Roth IRA. If you’re over 50 years of age, you can make an additional catch-up contribution of $1,000 each year.

The Roth IRA is also a great rollover option if you have a Roth 401(k) as a retirement account. You can roll the money from the employer-sponsored account, which has a required minimum distribution in retirement, to the Roth IRA, where there are no required distributions.

Who can get a Roth IRA?

In general, anyone with earned income (here’s what counts) in a given year can contribute to a Roth IRA. You can add up to the lesser of the maximum annual contribution or your earnings.

There is an exception, however, and it’s called the spousal IRA. If your spouse earns money, you and your spouse each are able to contribute up to the maximum contribution or your total annual income, whichever is less.

In addition, the Roth IRA places income limits on who can contribute directly, though you have ways around that. The limits for 2020 include:

  • If you’re an individual filer you can contribute the maximum amount if your modified adjusted gross income is under $124,000. The limit is reduced and phases out up to income of $139,000.
  • If you’re married filing jointly, you can contribute the maximum amount if your modified adjusted gross income stays below $196,000. The limit is reduced and phases out up to income of $206,000.

If you make above those amounts, you can still open a Roth IRA, but the route is a bit more roundabout using what’s called a backdoor Roth IRA. The short of it is that you can open a traditional IRA and then convert the account to a Roth, but here are the full details.

Roth IRA vs. traditional IRA

The other main kind of individual retirement account is the traditional IRA, and that can be a valuable savings vehicle for retirement, too. In contrast to the Roth IRA, the traditional IRA allows you to make contributions on a pre-tax basis, meaning you get a tax break this year on what you put in. At retirement (age 59 ½ or older), you’ll pay regular taxes on any withdrawals.

The traditional IRA does have income limits, so that if you make too much you won’t be able to use pre-tax money to do so. But you can convert the account to a Roth IRA and get a tax advantage that way. The traditional IRA has required minimum distributions in retirement.

Those are a few of the key differences between the two IRAs – here’s the complete rundown.

Bottom line

Because of its ability to shield taxes on earnings forever, the Roth IRA is one of the most popular retirement savings options. But don’t overlook the Roth IRA’s other valuable features, including no required minimum distributions and attractive estate planning benefits.

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