The Roth IRA. You’ve likely heard of it. You’ve likely been told you absolutely need one. But… why? What is it exactly? What are its advantages and disadvantages? Is it right for me? How do I even open one? If you’ve wondered about any of these, read on. We’ll discuss all of this and more.
What is a Roth IRA?
A Roth IRA is a type of retirement account. That’s all. Thanks for reading.
Don’t you wish it was that simple?
Let’s first talk about the IRA part of a Roth IRA. This is actually pretty simple. IRA stands for “Individual Retirement Account”. It is quite similar to a 401(k) in that respect. You put money in, you invest it, it grows, you start withdrawing in retirement, there are certain restrictions, and somewhere along the line there are tax advantages. This takes us into our next point. What does “Roth” mean? A Roth IRA (like a Roth 401(k)) has its tax advantages in retirement, whilea Traditional IRA (and 401(k)) has tax advantages now. In other words, with a Roth account, you pay income taxes at your current tax rate and your growth and withdrawals are all tax-free. If you choose to contribute to a Traditional IRA or 401(k), it will lower your taxable income. This will result in a lower tax liability right now instead of in the future.
What are the Rules and Restrictions?
In order to contribute to a Roth IRA, you must fall below a certain income based on your filing status. If you have too high of an income, there is a phase out and you become completely ineligible. Your Modified Adjusted Gross Income (MAGI) is the value used to calculate your eligibility. Your MAGI is the same as your Adjusted Gross Income (AGI) with the exception of some things added back. Some examples of what is added back are your IRA deduction, student loan interest, rental losses, qualified tuition expenses, and passive income or passive loss. In many cases your MAGI and AGI will be close, if not the same.
For 2018 the limits are as follows:
- Married Filing Jointly (and Married Filing Separately if not living with spouse)
- Phase out begins at $189,000
- Ineligible above $199,000
- Married Filing Separately (If living with spouse)
- Phase out begins immediately at $0
- Ineligible above $10,000
- Single Filers
- Phase out begins at $120,000
- Ineligible above $135,000
If you happen to be above the income limits (nice work!) then not all hope is lost. You can do what is called a backdoor Roth IRA which essentially dodges the income limit by allowing you to convert other retirement accounts to a Roth IRA.
For 2018 the maximum allowed contribution per year for a Roth IRA is $5,500. If you are over the age of 50 you can make an additional $1,000 catch up contribution each year.
You can contribute to both a Roth IRA and a Traditional IRA, but the limit is shared between the two. So, you could invest $2,000 in one and $2,500 in the other, as long as the total doesn’t exceed the limit in any given year. You can also have several Roth IRA accounts if you choose, but the total contributed still can’t be greater than the maximum allowed for the year.
If your income falls into the phase out portion, then your contribution limit is phased out linearly. For example, if you are married, the phase out is from $189k to $199k (a $10k difference), so every $1,000 above $189k you make will drop your max contribution by 10%. For singles, every $1,500 above the income limit reduces your max contribution by 10% since there is a $15,000 phase out period.
Lastly, your contribution amount cannot exceed your income. This prevents parents from putting money into a young child’s account and allowing it to grow longer. This would be pretty great though. A single contribution of $5,500 at the birth of a baby with a growth of 7% annually would be over $500,000 67 years later when they reach full retirement age. Crazy to think about, but that’s the power of compounding interest.
Withdrawals on Contributions
One of the most unique things about the Roth IRA is its policy on withdrawing contributions. Since you’ve already paid income tax on your contributions ( money that you’ve put into the account) you may withdraw them from the account tax-free and penalty-free at any point in time. This means, if you contributed $100,000 and it grew to $300,000 over time, you could withdraw the original $100,000 at any point in time with no penalty. There are other rules for taking out the earnings (the other $200,000) from your account though.
Withdrawals on Earnings
When it comes to withdrawing earnings from your Roth IRA, there are two things to concern yourself with, penalties and taxes.
To withdraw earnings from your Roth IRA tax-free you must have made your first contribution to the account at least five years ago.
To withdraw earnings from your Roth IRA penalty-free you must be 59½ or older or have the withdraw be a “qualifying exception”.
Common qualifying distributions include the following:
- Withdrawals due to death or disability
- Withdrawals to pay for first time home purchase (lifetime max of $10,000)
- Withdrawals to pay for certain unreimbursed medical expenses
- Withdrawals to pay for health insurance if unemployed 12 consecutive months
- Withdrawals to pay for postsecondary education expenses
- Substantially Equal Periodic Payments (SEPP)
The surefire way to avoid both taxes and penalties is to have made your first contribution over 5 years ago, and to be over 59½. If you don’t meet those requirements, you can avoid penalties (10% for 2018) by using your distribution for one of the qualifying expenses mentioned above. It is important to remember that these are only for the earnings. Contributions are always tax-free and penalty-free.
Required Minimum Distributions
A required minimum distribution (RMD) is a specific minimum amount that you must withdraw from an account each year once you hit a certain age. Roth IRAs, unlike 401k’s and Traditional IRAs, are not subject to RMDs. This means you never have to take withdrawals you don’t want to.
Why You Should Use a Roth IRA
Compounding Tax-Free Growth
The stock market has historically averaged a return of 10% annually (about 7% adjusted for inflation). Let’s look at what impact that has over time with a few examples.
With a rate of 7%, if you were to contribute $1,000 to an investment account at age 25, when you hit 67 it would have grown to over $17,000. In other words, having $1 at full retirement age would cost you 5.8 cents at age 25. The chart below shows how that $1,000 would grow over the course of the year, even without any additional contribution.
This compounding growth is true of any investment account, but on most non-retirement investment accounts you have to pay capital gains taxes. This benefit isn’t specific to the Roth IRA, but it is a huge advantage over a regular investment account. With the Roth IRA (as long as you’ve been using it for 5 years) you’ve already paid taxes on everything going in, so all of the gains and withdrawals are tax-free. The number you see in your account is what you’ll be able to take home. This makes understanding your balance extremely easy.
Potentially Lower Tax Rate
This is especially true for younger taxpayers. While it is impossible to predict the future, if you are at the infancy of your career it is likely that you will have a lower tax rate now than in retirement. This is an important factor when choosing between a Roth IRA/401(k) and a Traditional IRA/401(k). It is best to pay taxes when they are the lowest. If your taxes are lowest now, paying tax upfront with a Roth IRA is advantageous as opposed to paying on the withdraws at a higher rate in retirement like you would with a Traditional IRA. The tax rates also change with time though. Maybe the federal tax rate drops to a 5% flat tax. Maybe we go in the opposite direction and everyone pays a 50% tax. It is impossible to say. Choosing a Roth account essentially locks in the rate at which your investments are taxed to your current income tax rate.
Flexibility in Investments
Roth IRAs tend to have a much wider variety of investment options than employer sponsored 401(k)s. Some employers don’t even offer a 401(k) plan. You also have the flexibility to use whatever provider(s) you want. If you want access to specific mutual funds (such as the Vanguard Target Retirement funds) then you can open an account with that specific institution. Roth IRAs are often free and easy to open, you just have to keep the combined yearly contribution below the limit and you’re set.
Flexibility in Withdrawals
The withdrawal flexibility is a massive advantage of a Roth IRA that no other account can match. The ability to withdraw contributions at any time makes Roth IRAs very attractive. Combine this with the advantages of the specific qualifying distributions mentioned above, and they become an even more flexible option.
Here are a few examples of when that flexibility might be useful (not that we endorse these in all circumstances):
- You want to retire early and are on track to do so. If you want to retire at 50 (before other retirement accounts allow you to withdraw) you can withdraw on your contributions until you hit the age where you can make penalty-free earnings withdraws.
- You don’t want to be forced to take required minimum distributions. This allows you to keep your money invested and not be forced to cash out money you don’t need.
- You aren’t sure if your child will go to college, so you want to be able to save for college in some tax advantaged way, but not be penalized if they decide not to go.
- You want to save money for a home in the future and are dissatisfied with savings account rates.
- You cannot afford to contribute to a Roth IRA and emergency fund, but still want to invest. You can contribute to a Roth IRA and have it double as an emergency fund since you can withdraw contributions at any time.
I do recommend caution and consideration for the last three reasons. Since you are only able to contribute so much money every year, I’d only recommend those if you are unable to contribute the full amount, otherwise you are taking away from your actual retirement. You must also be able to tolerate a certain level of risk. Let’s go through an example scenario. Let’s say you had your Roth IRA double as a savings account and had contributed $1,000. Then the market had a bad streak and the value dropped to $800. Now you have a $800 emergency, but it actually costs you $1000. All of this to say, use extreme caution if you are attempting to use a Roth IRA for anything except as a retirement account.
The Maximum Contribution Has More Value Than Traditional IRAs
This is an often-overlooked point. The total IRA contribution limit is the same. This means you can put $5,500 (the 2018 max) in after-tax money into a Roth IRA and it will grow tax-free and be tax-free upon withdraw. Alternatively, you could put $5,500 of pretax money into a Traditional IRA. This costs you less since you aren’t paying tax on that $5,500 right now. Say both of those grow to $90,000. In the Roth account you’d have an actual $90,000 worth of take home money whereas the Traditional IRA’s $90,000 would be taxed on withdrawal. This doesn’t matter if you aren’t close to the contribution limit, but if you are at the limit, using a Roth allows you to effectively contribute more.
It is Difficult to “Catch Up” later
Let’s say you decide you like the idea of a Roth IRA but are thinking you might wait until next year to start contributing and just contribute extra to make up for it. Well, you can only contribute up to the limit, so every year spent not contributing is an opportunity you can’t get back. On top of that, just opening the account and making one small contribution starts that five-year timer to have tax-free withdrawals on your earnings. If you don’t use a Roth IRA, make sure that it’s because you choose not to, not because you procrastinated. Even if you were unable to contribute the maximum amount during the calendar year, you can still contribute to your account and count it as though it was from the prior year up to a specific date. The deadline for this changes every year. For reference, it was April 15th, 2018 for the 2017 contributions.
Why You Shouldn’t Use a Roth IRA
You Have High Interest Credit Card Debt
If you are paying interest on a credit card, not paying that off as fast as possible will very likely cost you more than you’d make by investing in a Roth IRA during that time period. You should still get your 401(k) match if your company has one, but the Roth IRA can wait. Kill that high interest debt as soon as possible. The only exception to this is if you are close to paying it off and the deadline for Roth IRA contributions is coming up. Then it might make sense to squeeze in a contribution before time is up for the year.
You Aren’t Getting Your Employer’s 401(k) Match
If your company offers a 401(k) match, do that first. Always. I personally recommend getting all of the match, then contributing to a Roth IRA if you can afford it. If you are able to max out your Roth IRA as well, then transition back over to the 401k or even an HSA. Not getting your employer’s 401(k) match is turning down free money.
You Have No Savings (Maybe)
If you are unable to contribute to both a Roth IRA and emergency savings account, it probably doesn’t make sense to save nothing in a normal savings account and dump all of your money into a Roth IRA. You don’t want to risk a big unexpected expense racking up credit card debt. As I mentioned earlier, you can technically use a Roth IRA as an emergency account, but there is definitely some risk involved. If you aren’t sure what is right for your individual situation, you should seek out personalized advice from a professional.
You Think You’ll Have a Lower Tax Rate in Retirement
If you are confident your tax rate will be lower in retirement than it is now, it could make sense to use a Traditional IRA. This could happen if tax rates are lowered in the future or if you will be making less in retirement than you are now.
You Want to Lower Your Tax Bill Now
This one is pretty simple. If you want to lower your current tax liability, then a Traditional IRA will do that, and a Roth IRA will not.
You Exceed the Income Requirements
If you make more than the maximum allowed to contribute to a Roth IRA, then you don’t get to. There isn’t much of a choice aside from the aforementioned backdoor Roth IRA. The good news is (as if making too much money wasn’t already good news) that there are no income limits for 401(k)s and Traditional IRAs, so there is still plenty of opportunity to save.
You Want to Prioritize Non-Traditional Investments
Last but certainly not least, you may not want to use a Roth IRA if you want to invest your money in some way other than with traditional retirement plans. This could include starting your own business, buying rental properties, etc. These types of investments can have a good amount of risk, but they can also be very rewarding. I would not let contributing to a Roth IRA be an excuse to put off working for yourself and achieving financial independence the way you want to.
How to Open a Roth IRA
Once you’ve decided if a Roth IRA is right for you or not, opening one is super easy. First you pick who you’d like to open an account with such as Vanguard, Fidelity, TD Ameritrade, etc. Once you’ve done that, you can generally sign up online. When I signed up for mine it took about 5 minutes. Once signed up I strongly recommend setting up direct deposit into the account and setting up automatic investment. That allows you to have everything automated so you don’t have to worry about it every paycheck and reduces temptation to spend investment money.
The Roth IRA is a fantastic investment account that offers great tax benefits and flexibility. It isn’t for everyone though. You should consider all of your options when deciding what is best for your individual situation. There is no one size fits all.
Do you have a Roth IRA account? If so, who is it with? What do you like and dislike about them? If not, are you planning on getting one? Let us know in the comments below!
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