What Is a Roth IRA?

One of the more popular retirement accounts is an individual retirement account, or IRA. IRAs come in two main forms: a traditional and a Roth IRA, and both generally function the same way. The main difference between them is how they are taxed.

Roth IRA vs. Traditional IRA

 

How a Roth IRA Works

A Roth IRA is a financial account that holds your investments. You can go to a bank or brokerage to open an IRA, where you can select your preferred assets. These can be bonds, stocks, mutual funds, exchange-traded funds (ETFs) or other financial products.

In a traditional IRA, your contributions may be tax-deductible (if you cannot contribute to an employer-sponsored plan). Any taxes assessed are taken when withdrawing money at retirement. A Roth IRA is different: the benefit comes by taxing the contributions before the money is placed in the account. As a result, your earnings are not taxed when you take retirement distributions. You won’t owe any money to the government in the future.

The Benefits of Opening a Roth IRA

A popular reason for choosing this type of IRA accounts is because you expect to pay a higher tax rate at retirement. You pay taxes on your contributions now (before it goes to the Roth account). Thus, you benefit by paying today’s lower tax rate on your contribution over the future (higher) one when you retire. This way your investment can grow tax-free.

Other benefits include:

  • You can have both a Roth IRA and a 401(k).
  • Contribution limits for the 2019 tax year are $6,000 ($7,000 for investors over 50 years old). These represent a $500 increase from the 2018 limits.
  • Withdrawals to contributions can be made at any time without penalty, taxes or restrictions. There may be an early withdrawal penalty on investment earnings.
  • You can receive distributions (inclusive of earnings) from your Roth IRA and avoid federal taxes. To do this, you must be 59½ or older and have owned your account for a minimum of five years.
  • Roth IRAs can be used to pay for qualified college expenses without earning an early distribution penalty. They can be substituted for, or used in addition to, a 529 plan. Note that while the penalty is avoided, there may still be income taxes you’ll need to pay.
  • There is no age limit for opening a Roth IRA. You can open a Roth IRA as long as you’re earning income. Investment income from rental properties, securities, or other assets is considered unearned income, and cannot fund a Roth IRA.
  • Roth IRA income can be passed as part of your estate. There is no mandatory minimum distribution requirement like in a 401(k) or traditional IRA.

Who Is Eligible to Open a Roth Account?

Once you have earned income this year, you are likely eligible to open a Roth IRA. There are a few limitations to this, namely income and contribution limits (which change every year).

In 2019, the Roth IRA Income and Contribution Limits are as follows:

Filing Status2019 Modified Adjusted Gross Income (AGI)Maximum Contribution
Qualified widow(er) or Married filing jointlyLess than $193,000$6,000 ($7,000 if 50 or older)
$193,000 to $202,999Contribution is reduced
$203,000 or moreNot eligible
Single, married filing separately, or head of household

(i.e. cases where  you and your spouse did not live together during the year)
Less than $122,000$6,000 ($7,000 if 50 or older)
$122,000 to $136,999Contribution is reduced
$137,000 or moreNot eligible
Married filing separately

(i.e. if you and your spouse lived together at any time during the calendar year)
Less than $10,000Contribution is reduced
$10,000 or moreNot eligible

Where Can You Go to Open a Roth IRA?

Roth IRAs can be opened at almost any investment company or bank. If you already have a traditional IRA opened with your bank or broker, you can also open a Roth account. That doesn’t automatically mean that your current financial institution is the best place to open your IRA. You should take the following considerations when deciding with whom you want to open the account:

  • Does the account have an opening or maintenance fee?
  • How do they deliver customer service: by phone, online, or in person? Does this match your needs?
  • What kind of investments does the company offer? Are these the kind of investments that you’re looking for?
  • What are the costs when buying and selling investments on the account?

Make sure you examine your options carefully to determine the best IRA for you.

How Much Can You Earn from a Roth IRA?

It depends. You’re likely to make more money if you start making contributions earlier. This is thanks to compound interest, which allows you to earn interest on top of interest previously earned. To see how the compound interest can affect your initial investment, check out our compound interest calculator.

Should You Choose a Roth IRA or a Traditional IRA?

Use this handy guide to compare IRA options and determine the best one for you.

RulesRoth IRATraditional IRA
2019 Contribution Limits49 years or younger - $6,000

50 or older - $7,000
49 years or younger - $6,000

50 or older - $7,000
2019 Income Limits• Tax filers who are single and have a modified AGI lower than $137,000 (phasing out from $122,000)

• Married couples who file jointly and have a modified AGI lower than $203,000 (phasing out from $193,000)
Investors can be anyone with earned income. Tax deductions will be based on the investor’s income limits and whether they participate in an employer-sponsored plan.
Age LimitsNo age limitsContributions allowed up to age 70 1/2
Tax CreditEligible for a “saver’s tax credit”Eligible for a “saver’s tax credit”
Tax TreatmentNo tax deduction available.

Earnings and withdrawals are tax-free in retirement.
Eligible for a tax deduction for the same tax year.

Regular income taxes applied to withdrawals.
Withdrawal RulesContributions can be withdrawn at any time and are tax-, and penalty-free.

Earnings withdrawals are tax-free provided you’re 59 1/2 and have had the account for at least 5 years.
From age 59 1/2 withdrawals are penalty-free.
Required Minimum Distribution (RMD)Account owners do not have a RMD.

Beneficiaries of the account are subject to RMD rules.
Account owners and beneficiaries are subject to RMD.  Account owners must start taking RMD at 70 1/2.
Extra Benefits• Up to $10,000 of earning can be used penalty-free to cover expenses for first-time home-buyers.

• Withdrawals for hardship and qualified education expenses may be taken penalty-free.
• Up to $10,000 of earning can be used penalty-free to cover expenses for first-time home-buyers.

• Withdrawals for hardship and qualified education expenses may be taken penalty-free.

In choosing an IRA, compare your current and retirement income and tax bracket. Where the higher tax bracket occurs will give insight into which type of account you should get.

Conclusion

When deciding to go with a Roth account, consider your options carefully. Look at the risks and benefits, and the terms and conditions. Regardless of what you choose, you should maximize your contributions each year, and start investing as early as you can.