- A Roth IRA is much like a traditional retirement plan, but involves paying taxes now so your withdrawals aren’t taxed later.
- A Roth IRA is a great option for younger people who have time on their side, or for those who may be in a higher tax bracket by retirement age.
- When opening a Roth IRA account, determine what kind of investor you want to be, who you want to invest your money, and where you want your money to go.
When it comes to retirement, building the right foundation in place is essential. For some, that foundation might be a 401(k) account with their employer. For others, retirement could be built on more than an employer-sponsored plan and include an individual retirement account (“IRA”).
Retirement is a highly personal matter, so understanding each option is paramount to building a retirement plan that works for you. We’ve covered the pros and cons of IRAs vs. 401(k)s, now let’s look deeper at how to open a Roth IRA and what might make this unique account the right choice for you.
What Is a Roth IRA?
A Roth IRA is a type of tax-advantaged individual retirement account that allows you to grow savings or investments until retirement by paying taxes at the time of contribution, and then make qualified withdrawals of your account contributions and earnings tax-free.
Like a traditional IRA, you need to know IRA withdrawal rules when using a Roth. For example, unlike a traditional IRA, you can withdraw your contributions to a Roth IRA at any time without paying income taxes or penalties.
Traditional vs. Roth IRA
When comparing a traditional IRA and Roth IRA, it’s all about the tax advantages between the two. Neither is necessarily better than the other, but each one offers something unique from the other.
A traditional IRA allows contributions that tax year to be deducted from your taxable income. This means you can lower your taxable income amount by making IRA contributions. Not everyone qualifies for this deduction to income, however. The deductibility of your contributions to traditional IRAs are subject to income limits if you or your spouse is covered by a retirement plan at work.
Another downside to the traditional IRA is that your withdrawals (your contributions and earnings) from the account are taxed, even after retirement. Essentially, you’re paying later for the money saved today. You also need to take minimum distributions from a traditional IRA once you hit 70 1/2 years old, so your account will slowly empty out.
Unlike a traditional IRA or 401(k), a Roth IRA doesn’t give you any tax benefit at the time of contribution. So, any contributions won’t help you lower your taxable income that year.
The benefits? Roth IRA contributions have higher income eligibility limits. Best of all, you won’t pay any taxes when you make qualified withdrawals. You also don’t have to make minimum withdrawals from your Roth account after retirement. This allows you to leave your account untouched if you want, making it a great nest egg to leave for your loved ones after you pass away.
Who Should Use a Roth IRA?
If choosing between traditional and a Roth IRA, consider the following:
With a traditional IRA you can lower your taxable income by contributing to your IRA before the end of the tax year. You then pay taxes when you retire and make qualified withdrawals. So, if you think you’ll be in a lower tax bracket upon retirement, this could be a safe route. If you think you might be in a higher tax bracket when you retire, then you might want to pay the income taxes when you contribute to your Roth IRA while you’re still in a lower tax bracket, since this account allows you to make qualified withdrawals upon retirement without paying taxes at the higher rate.
If you’re a young working professional with years to retirement, or someone who makes more than the traditional IRA contribution limits, or perhaps you’re someone who’s built wealth (or planning to) by investing diligently over the years, this route could save you thousands upon retirement, assuming your tax bracket is much higher.
Whether or Not You’ll Pull From Your Account
If you might need to withdraw from your retirement account prior to retirement (the IRS only allows withdrawals starting at age 59 1/2), note that your contributions to your Roth IRA can always be withdrawn without taxes or penalties. Any earnings in your Roth IRA are subject to withdrawal rules. In contrast, all funds in a traditional IRA are always taxed; penalties apply if withdrawn earlier than age 59 1/2 (with exceptions for hardship).
Lastly, if you don’t plan on actually taking money out of your IRA, you can theoretically leave a larger inheritance of retirement savings to your heirs using a Roth account. This is because your account can grow for your loved ones even after you’re gone, and there are no taxes due when your beneficiaries make qualified withdrawals.
In short, your IRA preferences come down to how badly you need the tax break today, and if you think you’ll be in a higher tax bracket when you retire. There are, of course, other investment account options, like a taxable investment account, that you can consider using in tandem with these tax-advantaged retirement accounts. As always, consider speaking with a financial advisor to solidify your retirement planning.
Opening a Roth IRA in 4 Steps
If you’ve decided to move forward with a Roth IRA, review the IRS requirements carefully, and look over your options thoroughly before choosing to go with any broker or company.
1. Check Roth IRA Eligibility
Not all people qualify for a Roth IRA. If you are married and file jointly, you can’t make more than $203,000 each year. For those who file individually, your income can’t exceed $137,000. The income limits are the primary criteria that can make you ineligible, so if your income falls within the guidelines, you will qualify for a Roth IRA.
If you’re not eligible for a Roth IRA on account of your income, there are Roth 401(k), 403(b) or governmental 457(b) plans available. These offer the same tax benefits as a Roth IRA, but don’t have the income limitations. If your employer offers matching contributions, contribute to your Roth 401(k) first prior to your Roth IRA to take advantage of that match. Note, however, that employer matching contributions will be tax-deferred funds, meaning this portion of your 401(k) will be taxed upon withdrawal.
If you have a Roth 401(k) plan and you leave your job, you can roll that account into a Roth IRA to keep growing your account.
2. Know the Contribution Limits
As is the case with tax-advantaged retirement accounts, there are contribution limits to be aware of. These limits can’t be exceeded without incurring a penalty, so be mindful of them.
For a Roth IRA account, the contribution limit in 2019 is $6,000 with an additional $1,000 for employees that are age 50 and over.
3. Decide Where to Open Your Roth IRA
You have three primary routes you can take with a Roth IRA: do-it-yourself brokerage, a financial advisor, or a robo-advisor.
If you’re the type that likes to learn a lot and manage tasks yourself, going through an online brokerage is likely the solution for you. This allows you to go online, build your own diversified portfolio, and choose your investments yourself. There are online fees and commissions to pay, but these fees are often less than those associated with a professional investment manager. These lower fees can make the online brokerage route attractive, especially if you’re just starting out.
Traditional brokerage involves a paid financial consultant or licensed broker who can guide you through the entire investment process and create a Roth IRA portfolio that fits your goals. Investment managers can sometimes have hefty management fees of up to 2% of assets under management, but many people turn to them to help ensure they have a healthy retirement income when the time comes. This route, while sometimes costly, is ideal for those uncomfortable with the thought of building their own portfolio and want the one-on-one relationship of a financial advisor.
Lastly, there are robo-advisors. A robo-advisor uses technology to apply their investment policy to choose investments for you, taking out the guesswork. Robo-advisors often have some management fees or service fees attached as well, but they can be more affordable than a financial consultant. If you’re considering a robo-advisor, be sure to read up on the top robo-advisor options ahead of time.
4. Understand Your Investment Style
Once you decide where to open your account, it’s time to know how you want to invest. How your money is invested makes a huge difference. Short-term, aggressive growth in a few high-flying stocks could mean your account grows noticeably in a few years, but also that your savings can take a dive due to a collapsed market. Long-term, safe growth could mean you’re left with less actual growth, but growth that doesn’t keep up with inflation. Finding the mix of investments that gives you income and gains with the appropriate amount of risk — and that meet your personal goals and risk tolerance — is the key.
If you’re going the DIY route, you’re going to want to do some heavy homework to learn about investing to make an educated decision on where your money should go.
If you’re going with a financial advisor, they’ll likely ask you about your retirement goals and risk tolerance. Do you want aggressive growth? Or, are you more comfortable playing it a little safer? Your answers will help a financial advisor understand where your money should go. Consider selecting an advisor who follows the fiduciary standard, meaning the advisor is obligated legally to work in your best interest above their own.
Similarly, a robo-advisor will also ask questions about your financial goals, which will help it determine the appropriate ready-made investment portfolio for your money.
Make It Official: Open Your Roth IRA
It’s time to make your Roth IRA official. Now that you’ve learned about the Roth IRA rules and weighed your options carefully, you can make the best decision of whether the Roth IRA is right for you. You’re also ready to move forward on your own, or with a financial advisor or robo-advisor. While you want to be careful, remember that the sooner you start, the sooner your Roth IRA and other investment accounts will grow.