It's never too early to start saving for retirement. After all, nobody wants to worry about money in their golden years. One option you can take is by opening a Roth individual retirement account (IRA).
But, what is a Roth IRA, exactly? What makes it different from other investment options?
In this article, we'll talk about how a Roth IRA works, how it differs from a traditional IRA, and how to begin applying for a Roth IRA. We'll also provide a few tips on investing in a retirement account and withdrawing your earnings tax-free.
What Is Roth IRA?
The Roth IRA was first introduced as part of the Taxpayer Relief Act of 1997. It was named after William Roth, the former Delaware senator who sponsored the program.
As its name suggests, a Roth IRA is a type of individual retirement account. Like traditional IRAs, they're accounts that hold your investments rather than being investments themselves. You're free to have more than one Roth IRA at a time.
You can make a lump sum contribution or make regular contributions to your account throughout the year, as long as you don't exceed the annual contribution limits set by the IRS. Roth IRA contributions will not be tax-deductible, but you can withdraw your earnings tax-free upon retirement.
Once you've made contributions to your individual retirement account, the next step is to invest that money and allow it to grow. With an IRA, you're free to select if you want to invest in mutual funds, stocks, bonds, or exchange-traded funds.
For instance, you can contribute $6,000 to an IRA and invest $4,000 in stocks and $2,000 in bonds. You'll be in charge of where to allocate the money, then make periodic adjustments, depending on your risk tolerance.
Due to the nature of Roth IRAs, you can earn or lose money depending on how you choose to invest your funds. So, you need to have a solid investment strategy when choosing where to put your money.
Roth IRA vs Traditional IRA
Contributions made to traditional IRAs are automatically tax-deductible, while contributions made to Roth IRAs are taxed. On the bright side, Roth IRA offers tax-free growth and tax-free withdrawals upon retirement.
If you expect to be in a high tax bracket during retirement, a Roth IRA may be more advantageous for you compared to a traditional IRA. That's because you can withdraw your earnings tax- and penalty-free after age 59 1/2 and after the account has been open for five years.
On the other hand, if you don't think you'll have a considerable income in the future, you're better off choosing a traditional IRA because it offers tax-free benefits upfront.
To put it simply, Roth IRAs are similar to traditional IRAs, except when it comes to the manner in which they're taxed. It's possible to switch from owning a traditional IRA to a Roth one. You'll have to convert traditional IRA funds to Roth IRAs by paying income taxes on any account balance that has not already been taxed.
IRAs vs 401(k)s
Both IRAs and 401(k)s offer benefits in terms of taxes, but there are a few key differences.
First off, IRAs are opened by individuals, while 401(k)s are offered by employers. Another key difference is that contributions made to a 401(k) can be deducted from your taxes at the end of the tax year. However, distributions you receive in retirement will be taxed as ordinary income.
The maximum annual contribution is smaller with Roth IRAs, but you'll also have more control over your investment options. Plus, there are no required minimum distributions in retirement, so you're free to let your investments grow over time.
If you're finding it hard to choose, you should know that you're free to contribute to an IRA as well as a 401(k) at the same time.
Advantages Of Roth IRAs
Aside from giving you the opportunity to withdraw your earnings tax-free upon retirement, here are other benefits of choosing to invest in a Roth IRA.
Any person can contribute to a Roth IRA as long as their earned income for the year meets the requirements. You can also make contributions at any age, as long as you've earned income for the year.
Withdraw Your Contributions Anytime
Direct contributions (principal) you've made to your Roth IRA can be withdrawn at any time without incurring taxes. If you need cash for an emergency, like a sudden loss of income, you won't have trouble getting money from your retirement account.
You can contribute to an IRA any time before the tax calendar. You're not obligated to put in money if you don't have extra cash for a certain period.
Qualify For A Tax Credit
People with lower and middle-income can receive up to $1,000 or ($2,000 for joint filers) for contributing to a Roth IRA. This payment will come in the form of a tax credit.
No Required Minimum Distributions (RMDs)
You're not required to make any withdrawals throughout the Roth IRA's validity period. That way, you can let your savings grow, even if you're older. Meanwhile, other tax-deferred retirement plans require you to withdraw money starting April 1 on the calendar year after you reach age 70 1/2.
Fund Your Education
You can withdraw earnings from your Roth IRA to pay for college or graduate school. This money can be used to fund higher education for yourself, your spouse, or your child.
While your Roth IRA withdrawals will be exempt from incurring a 10% penalty, you need to have held the account for five years for the money to be exempt from taxes.
No Taxes For Beneficiaries
If the Roth IRA gets passed down to your beneficiaries, they don't have to pay income taxes on the withdrawals. In case your sole beneficiary is your spouse, they can also combine their own Roth IRA with yours.
Are You Eligible For A Roth IRA?
Your filing status and modified adjusted gross income (MAGI) will determine if you're eligible to contribute to a Roth IRA. Let's look at contribution and income limits to understand this concept.
The Roth IRA contribution limit for the tax year 2020 is at $6,000 for people under age 50. Meanwhile, Roth IRA contribution limits for those who are above age 50 at $7,000.
If your income for the year is higher, the amount you can contribute to your Roth account begins to diminish until the ability to contribute is gone completely. That means you're ineligible to contribute to a Roth IRA.
For example, if you're a single filer and your 2020 modified adjusted gross income is $124,00 up to $139,000, you'll have lower contribution limits. Similarly, if you're a married couple filing jointly, and have earned a combined amount of $196,000 up to $206,000, your contribution limits will also be lower.
If you contribute more than the annual income limit, you can incur a penalty from the IRS. Therefore, it's important to keep tabs on your Roth IRA contributions, especially if you have more than one account.
The Roth IRA income limit in 2020 is $139,000 of MAGI for singles. Meanwhile, the income limit for joint filers is set at $206,000 MAGI. That means, if your income is higher than this amount, you're not eligible to contribute.
Income limits are adjusted by the IRA annually. While you may not be eligible this year, you can be qualified to make contributions next year.
Funding A Roth IRA
Taxable income isn't the only thing you can use to fund your IRA. You can also put in commissions and bonuses, as well as alimony or child support payments. However, you can't use annuity income, interest income, stock dividends, or rental income.
Withdrawing Roth IRA Contributions
People with Roth IRAs can withdraw contributions tax-free if they meet certain requirements. Withdrawals that are free of both taxes and penalties are called qualified distributions, while those that incur taxes or penalties are called non-qualified distributions.
You can withdraw an amount that's equal to the one you've contributed any time, regardless of your age. The distribution is not considered taxable income and is not subject to penalties or taxes.
On the other hand, you'll need to wait at least five years if you want to withdraw from your Roth account in the following situations:
If you plan to withdraw account earnings
If you convert a traditional IRA into a Roth IRA
If a beneficiary inherits the Roth IRA
You must also meet at least one of these requirements:
The Roth IRA owner is at least age 59 1/2.
If the withdrawal will be used to purchase, build, or rebuild a first home for the Roth IRA holder or a spouse, child, grandchild, a parent, or another ancestor, it's considered tax-free. Note that there's a maximum withdrawal amount of $10,000 for this option.
The IRA owner has become disabled.
The assets are distributed to the beneficiary of the Roth IRA holder after the account owner's passing.
For those who own multiple Roth IRAs, the waiting period starts on January 1 of the year you contributed to your first Roth IRA, not necessarily the one you're withdrawing funds from.
If you don't wait five years, you'll have to pay income taxes on earnings withdrawals, plus a 10% penalty. However, there are a few exceptions, such as withdrawing money to pay for medical insurance or to fund childbirth or adoption.
Tips For Investing In A Roth IRA
Nobody wants to lose their hard-earned income by making bad investments. To help you make the most out of your Roth IRA and earn more for retirement, here are a few tips.
It's best to open a Roth IRA while you're young. Since your salary is likely to be lower compared to later in your career, you can make more contributions every year. You won't be bothered too much by the income limits set by the IRS.
Determine Your Risk Tolerance
One of the most important steps to take when it comes to investing your Roth IRA funds is to determine your risk tolerance. This refers to how much losses you're willing to risk to get a high return.
For example, if you're young, your ability to take risks and recover from setbacks would be higher than someone who's already close to retirement.
Diversify Your Portfolio
As they say, never put all your eggs in one basket. When it comes to investing, that means maintaining a diversified portfolio of stocks, mutual funds, real estate investment trusts (REITs), and exchange-traded funds (ETFs).
In general, you can classify your portfolio as "conservative," "balanced," "growth," and "aggressive growth." The more you invest in stocks, the more aggressive your portfolio becomes. This can potentially lead to higher losses, but it also allows you to score higher returns if the value of your stocks rises.
Max Out Your Roth IRA
Your maximum IRA contributions per year will depend on your income, but as much as possible, try to max it out. The more money you put in, the larger your account can grow and the more tax-free earnings you can get during retirement.
Ride The Highs And Lows
Whenever the value of stocks falls, it's normal to panic. But, that doesn't mean you should start withdrawing all your contributions or contributing less.
Investing your income so that you have enough money during retirement is like a marathon. Read up on investing and see which moves are best to take in order to maintain the value of your IRA even when the market dips.
Adjust Your Portfolio Over Time
It's important to "rebalance" your portfolio periodically to see what adjustments you can make, depending on the changes to your risk tolerance. For example, you can begin with a portfolio that's 70% stock funds and 30% bond funds when you're young. As you grow older, you might want to switch to a more conservative portfolio.
Ask For Help
It's never wrong to ask people what you should do with the money you've put into your Roth IRA. If you want serious advice, however, it's best to ask one from a qualified financial advisor.
Before hiring someone to help you manage your account, check their credentials and consultation fees. Also, don't forget to check if they're registered as an investment advisor with the U.S. Securities and Exchange Commission or with the state. This will ensure that they're qualified to give you investment advice.
Choosing A Roth IRA Provider
Only institutions that have received IRS approval can offer IRAs. These institutions include online brokers, federally insured credit unions, loan associations, and banks.
When choosing where to open a Roth IRA, ask the provider what options they offer for investments. Some institutions allow you to invest in a wide variety of securities, while others can limit your options.
Also, if you plan to adjust your portfolio regularly, look for a provider with low trading costs. That way, you don't have to pay money each time you buy and sell stocks, bonds, or any other securities.
You may also let some Roth providers manage your investment portfolio for you. All you have to do is make your regular contributions then watch your savings grow.
Note that Roth IRA providers have varying minimum balances. This will limit the withdrawals you can make on your principal.
Everyone wants a comfortable retirement. Investing money in a Roth IRA is one of the ways that you can make that dream a reality. It's especially beneficial if you expect to be in a higher tax bracket during retirement because withdrawals on earnings are tax-free past age 59 1/2.
Are Roth IRAs the best for you? Contact our team at Wesley Mortgage, LLC to learn more about your options. We'll help you put your money to work so you can have a stress-free retirement.