What is a Roth IRA?
A Roth IRA is a type of individual retirement account that grows money in a tax-deferred manner. Money deposited in a Roth IRA account is not tax deductible, meaning you will have to pay taxes on the deposited funds. However, unlike a typical IRA account –where premature withdrawals are taxed – Roth IRA withdrawals are not liable for taxes, as long as the account has been maintained for a minimum of 5 years and the withdrawals occur after 59.5 years of age.
As of 2021, you can contribute a maximum of $6,000 to a Roth IRA account, if you are under the age of 50, and $7,000, if you are 50 and older. To be eligible to open a Roth IRA account, you need to have earned Modified Adjusted Gross Income (MAGI) of $140,000, if you are a single filer, or $208,000, if you are married and filing jointly.
Among the advantages of Roth IRAs are tax-free withdrawals and the absence of mandatory required minimum distributions after a certain age. The disadvantages of Roth IRAs include income restrictions and the decline in present income due to tax liabilities resulting from contributions to such accounts.
Basics of Roth IRA
Roth IRAs were originally called “IRA Plus” and are named after Delaware Senator William Roth, who sponsored legislation to create them. Roth IRAs differ from traditional IRAs in certain respects. While the latter has mandatory required minimum distributions (RMD) after a certain age to maintain their tax-free status, Roth IRA funds can be withdrawn at any time and in any frequency after the age of 59.5 years without incurring additional taxes. Roth IRAs are also similar to traditional IRAs in several respects. For example, like traditional IRAs, they can be started at any age. You can rollover your funds from company-sponsored retirement plans into Roth IRAs and pass them onto beneficiaries tax-free.
While Roth IRA accounts allow securities trading, contributions to the account must be made in cash, such as bank funds or checks. Therefore, you cannot make contributions to your account in the form of securities, such as stocks and bonds, or assets, such as property. They must also be made using earned income i.e., income that is a result of employment, for another entity or for self. You cannot use income from other sources. For example, you cannot make contributions to your Roth IRA using profits from the sale of a stock.
Roth IRA accounts are tax-deferred accounts, meaning any gains accrued from trades using assets inside the account will be due for taxes later.
What Are the Advantages and Disadvantages of Roth IRAs?
As a financial instrument for retirement planning, Roth IRAs offer several advantages comparable to those of their traditional counterpart.
Some of them are listed below:
- Roth IRAs offer tax-free retirement income. While contributions to Roth IRA accounts are made with after-tax income, Roth IRA account holders can withdraw funds without incurring taxes, provided they are above 59.5 years of age and have made a minimum of five years of contributions to their accounts.
- Depending on income, Roth IRAs can offer tax advantages to low- and middle-income households. Saver’s Credit offers tax credits of 50%, 20%, and 10% of the total MAGI depending on the income of the Roth IRA account holder. For example, married individuals filing jointly and with an adjusted gross income of less than $39,500 in 2021 are eligible for a 50% credit on their contribution to their individual Roth IRA account.
- Roth IRAs do not have required minimum distributions. In a traditional IRA, you must begin taking out required minimum distributions starting at the age of 72. Else, your withdrawals are charged at regular rates. Roth IRAs have no such requirement, making it easy to withdraw funds at any time for account holders.
- Roth IRA funds can be rolled over into other financial instruments, such as trusts, or their balance in a Roth IRA account can be increased using funds from other instruments, such as company-sponsored retirement plans.
- The tax-free status of Roth IRA funds can be passed onto beneficiaries through specially-formulated Trusts. Depending on the type of trust, income distributions from it are considered tax-free. The final dissolution of a trust, after it has run its course, also results in tax-free distribution of its contents to beneficiaries.
The disadvantages of Roth IRAs are as follows:
- Roth IRA contributions are not tax-deductible because they are made with after-tax money, i.e., after taxes have been applied to your income. Therefore, the overall effect of the contributions is that they decrease your present income without offering any benefits in return. For example, suppose you earned $80,000 in after-tax income for a given year and made the maximum possible contribution of $6,000 for a single filer to your Roth IRA. Then your income for that year reduces to $74,000.
- Roth IRA accounts have income restrictions. They can only be opened by individuals below a certain income defined by the modified adjusted gross income (MAGI) provision. If you earn income above the MAGI for a given year, then you are not eligible to open a Roth IRA account. This is unlike IRA accounts, which can be opened by anyone irrespective of income.
Opening a Roth IRA Account
To open a Roth IRA account, you need to visit a bank or a brokerage with the necessary documentation, such as proof of income and identification. While opening an account, it is important to consider its purpose. For most individuals, the primary purpose of a Roth IRA account is retirement planning. To achieve this goal, you can consider a wide variety of financial instruments, such as mutual funds, stocks and bonds, ETFs or any combination thereof. It might be wise to ask yourself important questions relating to the account’s purpose.
Some of these questions are as follows:
- How frequently do you plan to trade from your account? If you plan to trade frequently, then it is a good idea to open your account at a brokerage as opposed to a bank. Trading fees are also an important consideration here. The lower the fees, the more you are likely to trade more.
- What is your tolerance for risk? Retirement accounts are generally designed to stash money for safekeeping. As a result, use of speculative assets and instruments is kept to a minimum. Your portfolio inside a Roth IRA account can consist of a mix of conservative instruments like mutual funds, that provide fixed returns with minimal risk, and securities like stocks that will provide you with gains. Depending on your tolerance for risk, you can assign a certain percentage of your Roth IRA funds between conservative and risky instruments.