What Is a Roth IRA?

A Roth IRA is an individual retirement account (IRA) that permits tax-free withdrawals under certain conditions. It was founded in 1997 and is named after former Delaware Senator William Roth.

Roth IRAs are identical to standard IRAs, with the primary difference being the way they are taxed. Roth IRA contributions are made after-tax monies; they are not tax-deductible. However, once you begin withdrawing funds, the monies are tax-free. On the other hand, traditional IRA contributions are often made using pretax monies; you typically receive a tax deduction for your contribution and pay income tax on withdrawals from the account during retirement.

For some retirees, this and other significant distinctions make Roth IRAs a better alternative than standard IRAs.

KEY TAKEAWAYS

• A Roth IRA is a type of retirement plan in which you pay taxes on contributions but not on withdrawals.
• Roth IRAs are advantageous if you anticipate that your taxes will be higher in retirement than today.
• If you earn too much money, you cannot contribute to a Roth IRA. In 2021, the singles cap will increase to $140,000. The limit for married couples is $208,000.
• Your contribution amount is subject to change periodically. In 2021, the annual contribution ceiling will be $6,000, unless you are 50 or older, in which case it will increase to $7,000.
• Almost every brokerage firm, in-person or online, offers a Roth IRA. Likewise, the majority of banks and investment firms do.

Understanding Roth IRAs

As is the case with other eligible retirement plans, money invested in a Roth IRA grows tax-free. However, a Roth account is less restrictive in several ways than other types of accounts. Contributions are permitted at any age as long as the account user earns a living. The account holder may continue contributing to the Roth IRA indefinitely; unlike 401(k)s and traditional IRAs, there are no required minimum distributions (RMDs) during the account holder’s lifetime.

A Roth IRA can be funded in a variety of ways::

• Contributions consistently
• Contributions to a spouse’s IRA
• Transpositions
• Contributions that are carried over
• Adaptations

All contributions to a standard Roth IRA must be made in cash (including checks); they cannot be contributed in the form of stocks or other assets. However, after funds are committed to a Roth IRA, a range of investment options are available, including mutual funds, equities, bonds, ETFs, certificates of deposit, and money market funds.

The IRS caps the amount that can be put in any IRA, occasionally revising the limitations. The contribution limits for regular and Roth IRAs are identical.

$6,000

In 2020 and 2021, an individual’s maximum yearly contribution to a Roth IRA remains unchanged. Individuals 50 years of age and older may give up to $7,000.

Opening a Roth IRA

A Roth IRA must be opened with an institution that the IRS has approved to offer IRAs. Banks, brokerage firms, federally insured credit unions, and savings and loan associations are all examples of this type of institution. Individuals typically open IRAs through brokers.

Any time can be used to establish a Roth IRA. On the other hand, contributions to an IRA must be made by the IRA owner’s tax filing date, which is typically April 15 of the following year. Extensions of time to file taxes do not apply.

The Internal Revenue Service (IRS) stated on March 17, 2021, that the due date for submitting federal income taxes for all taxpayers for the 2020 tax year would be automatically extended from April 15, 2021, to May 17, 2021. This also delays other tax-related deadlines; for example, the deadline to contribute to an IRA is typically April 15, but people will have additional time this year.

Individuals and businesses impacted by the winter storms in Texas in 2021 will have until June 15, 2021, to file different individual and corporate tax forms, make tax payments, and contribute to their 2020 IRAs. (The IRS announced the extension for victims of the 2021 winter storms on February 22, 2021.)

When an IRA is founded, two essential documents must be submitted to the IRA owner:

• The disclosure statement for an IRA
• The agreement and plan document for the adoption of an IRA

These documents explain the laws and regulations that govern Roth IRAs and establish a contractual relationship between the IRA owner and the IRA custodian/trustee.

Financial institutions are not all created equal. While some IRA providers offer a broad range of investing possibilities, others are more limiting. Almost every institution has a unique cost structure for Roth IRAs, which can significantly affect your investment returns.

Your risk tolerance and investing choices will be factors in determining which Roth IRA provider to use. If you intend to be an active investor who executes numerous transactions, you’ll want to choose a provider with inexpensive trading expenses. Certain providers will charge you an account inactivity fee if you do not touch your investments for an extended period. Certain providers provide a broader selection of stocks and exchange-traded funds than others; it all depends on the type of investments you wish to make in your account.

Pay close attention to the account’s specific criteria as well. Certain providers need a higher minimum amount in your account than others. If you intend to bank with the same institution, inquire about the availability of other banking products with your Roth IRA account. If you’re considering starting a Roth with a bank or brokerage where you already have an account, inquire about any IRA fee discounts available to current customers. 

Roth IRA Vs. Traditional IRA

Are Roth IRAs Insured?

If your account is held with a bank, keep in mind that IRAs are insured differently from traditional deposit accounts. As a result, coverage for IRA accounts is less comprehensive. The Federal Deposit Insurance Corporation (FDIC) continues to insure traditionally, or Roth IRA accounts up to $250,000. However, account balances are aggregated rather than displayed individually.

For instance, if the same banking client has a $200,000 certificate of deposit housed within a traditional IRA and a $100,000 Roth IRA housed within a savings account at the same institution, the account holder has $50,000 in uninsured assets.

What Can You Contribute to a Roth IRA?

The IRS regulates not just the amount of money deposited in a Roth IRA but also the type of money that can be deposited. In general, you can contribute to a Roth IRA only with earned income.

Wages, salaries, commissions, bonuses, and other remuneration provided to an eligible employee to finance a Roth IRA include wages, salaries, commissions, bonuses, and other monies provided to the employee for services rendered. Generally, it is any sum listed in Box 1 of an individual’s Form W-2. Compensation for a self-employed individual or a partnership partner is defined as the individual’s net earnings from their business. Fewer deductions allowed for contributions made on the individual’s behalf to retirement plans and further reduced by 50{e1706a52c3b3138427a8e72931d9d59b6d08ac610477d60aad46d317c02b8d31} of the individual’s self-employment taxes.

Contributions can also be made for divorce-related expenses such as alimony, child support, or a settlement.

Thus, what kind of funds are ineligible? The list contains the following::

• Profits from rental properties or other sources derived from property maintenance
• Income from interest or pensions or annuities
• Dividends and capital gains on stocks

Never contribute more to your IRA than you earned in a given tax year. Additionally, as previously stated, you do not receive a tax deduction for the contribution—although you may be eligible for a Saver’s Tax Credit of 10{e1706a52c3b3138427a8e72931d9d59b6d08ac610477d60aad46d317c02b8d31}, 20{e1706a52c3b3138427a8e72931d9d59b6d08ac610477d60aad46d317c02b8d31}, or 50{e1706a52c3b3138427a8e72931d9d59b6d08ac610477d60aad46d317c02b8d31} of the deposit, depending on your income and life circumstances.

Who’s Eligible for a Roth IRA?

Anyone with taxable income is eligible to contribute to a Roth IRA—as long as they meet specific criteria regarding their filing status and modified adjusted gross income (MAGI). Individuals whose annual income exceeds a specific threshold, which the IRS adjusts quarterly, lose their eligibility to contribute.

The Spousal Roth IRA

One approach for a couple to increase their contributions is through the use of a spousal Roth IRA. A person may contribute to a Roth IRA on behalf of their married partner who has a low or no income. Contributions to a spousal Roth IRA are subject to the same regulations and limitations as contributions to a standard Roth IRA. The spousal Roth IRA must be kept separate from the contributor’s Roth IRA, as:

• A married pair must file a combined tax return.
• The spouse making the Roth IRA contribution must be compensated appropriately.
• Both spouses’ combined contributions cannot exceed the taxable compensation recorded on their joint tax return.
• Contributions to a single Roth IRA cannot exceed the IRA’s contribution restrictions (however, the two accounts allow the family to double their annual savings).

Withdrawals: Qualified Distributions

You may withdraw contributions from your Roth IRA tax and penalty-free at any time. Suppose you withdraw only the amount you invested. In that case, the distribution is not considered taxable income and is therefore not subject to penalty, regardless of your age or the length of time the money has been in the account. This is referred to as a qualified distribution by the IRS.

However, there is a caveat regarding withdrawing account earnings—that is, any profits made by the account. To be qualified, account earnings must be distributed at least five years after the Roth IRA owner opened and funded his or her first Roth IRA and must meet at least one of the following conditions:

• When the payout occurs, the Roth IRA owner must be at least 5912 years old.
• The distributed assets are used to purchase—or to construct or rebuild—a first home for the Roth IRA owner or a qualified family member (the IRA owner’s spouse, a child of the IRA owner or his or her spouse, a grandchild of the IRA owner and their spouse, a parent or other ancestor of the IRA owner or their spouse). This is capped at $10,000 per person, per lifetime.
• After the Roth IRA owner becomes disabled, the distribution occurs.
• After the Roth IRA holder’s death, the assets are dispersed to the Roth IRA holder’s beneficiary.

The 5-Year Rule

Withdrawals of earnings may be taxed and subject to a 10{e1706a52c3b3138427a8e72931d9d59b6d08ac610477d60aad46d317c02b8d31} penalty, depending on your age and compliance with the 5-year Rule. Here is a quick recap.

If you comply with the five-year Rule:

• Earnings are subject to taxes and penalties under 5.5. You may be eligible to avoid paying taxes and penalties if you use the funds to purchase a first home (a $ 10,000-lifetime maximum applies), if you have a permanent disability, or if you die (and your beneficiary takes the distribution).
• No taxes or fines if you are 59.5 years old or older.

If you don’t meet the 5-year Rule:

• Earnings are taxed and penalized under 59.5. You may be able to avoid the penalty (but not the taxes) if you use the funds for a first-time home purchase (a $ 10,000-lifetime maximum applies), eligible school expenditures, unreimbursed medical expenditures, or if you die (and your beneficiary takes the distribution).
• 59.5 years and older: Earnings are taxed but not penalized.

Withdrawals: Non-Qualified Distributions

Earnings distributions that do not meet the criteria mentioned earlier are deemed non-qualified distributions and may be subject to income tax and a 10{e1706a52c3b3138427a8e72931d9d59b6d08ac610477d60aad46d317c02b8d31} early-distribution penalty. However, there may be exceptions if the funds are used:

• For medical expenses that have not been paid. Suppose the distribution is utilized to cover unreimbursed medical expenses above 10{e1706a52c3b3138427a8e72931d9d59b6d08ac610477d60aad46d317c02b8d31} of the recipient’s adjusted gross income (AGI) for the distribution year. (This 10{e1706a52c3b3138427a8e72931d9d59b6d08ac610477d60aad46d317c02b8d31} figure is for withdrawals made after 2012.) Previously, it was 7.5 percent of AGI.)
• To cover medical expenses. Suppose an individual has been laid off from his or her employment.
• For eligible post-secondary education expenses. Suppose the distribution is used to pay for the Roth IRA owner’s qualifying higher education expenditures and those of his or her dependents. These qualified education expenses must be used in the year of withdrawal and include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an authorized educational institution.
• To cover the costs of delivery or adoption. Grants of up to $5,000 are available if made within one year following the event.

It’s worth noting that if you withdraw solely the number of contributions made during the current tax year — including any gains on those contributions — the contribution is reversed. For instance, if you contribute $5,000 in the current year and the funds earn $500, you can take the $5,000 principal tax and penalty-free, while the $500 gain is taxed as ordinary income.

Roth IRA vs. Traditional IRA

Whether a Roth IRA is more advantageous than a traditional IRA is determined by the filer’s tax bracket, the anticipated tax rate at retirement, and personal preference.

Individuals who anticipate being in a higher tax rate upon retirement may find the Roth IRA more advantageous, as the total tax avoided in retirement will be greater than the current income tax paid. As a result, Roth IRAs may assist younger and lower-income workers the most. Indeed, by starting early in life with an IRA, investors take advantage of compound interest’s snowball effect: your investment and earnings are reinvested, which generates additional earnings, which are reinvested, and so on.

Naturally, even if your expected tax rate in retirement is lower, you’ll still benefit from a tax-free income stream from your Roth. Not the worst idea ever.

Individuals who do not require their Roth IRA assets in retirement can leave them to accumulate indefinitely and pass them on to their heirs tax-free. Even better, while the beneficiary is required to accept withdrawals from an inherited IRA, they can extend tax deferral by accepting distributions for a decade or, in some unique instances, for the remainder of their lives.

Beneficiaries of traditional IRAs, on the other hand, must pay taxes on distributions. Additionally, a spouse may roll over an inherited IRA into a new account and defer distributions until retirement. Some individuals open or convert to Roth IRAs out of concern for future tax increases, and this account enables them to lock in current tax rates on the number of their conversions. Executives and other highly compensated employees eligible to contribute to a Roth retirement plan offered by their employers [for example, a Roth 401(k)] can also roll these plans into Roth IRAs tax-free and avoid having to take mandatory minimum distributions when they reach retirement age.