What is a ROTH IRA?
A Roth IRA is a type of individual retirement account used to save for retirement.
The Roth IRA is widely used because it is tax-advantaged relative to standard brokerage accounts or savings accounts. Once a Roth IRA account has been set up and funded, investment gains can accumulate without incurring the need for the account holder to pay any taxes.
These massive tax savings have made it a popular investment option.
How Roth IRAs Work
The IRS has provided very specific eligibility requirements that it updates on an annual basis.
To be eligible to set up a Roth IRA account, you must be under the age of 70½, have earned income in the past year, and fall within a certain income range for your tax status.
For example, if your tax status is married filing jointly and your taxable income is greater than $500,000, you are not eligible to contribute to an IRA because you earn too much money.
However, with that same tax status and a taxable income of $150,000, you would be able to contribute to a Roth IRA under the current IRS rules.
Roth IRA accounts can only be funded with post-tax income up to the contribution limit set by the IRS for your tax status and level of income. Post-tax income refers to income that has already been reduced by income taxes.
For 2019, the maximum contribution limit for a Roth IRA was $6,000 for people under the age of 50 and $7,000 for people age 50 and older.
Once an account is funded, the money can be invested in a wide variety of financial assets, including stocks, bonds, and mutual funds. Investment decisions are at the discretion of the account owner.
The account owner can withdraw the initial post-tax income contributed to the account at any time without a tax penalty. However, if the account owner withdraws funds considered capital gains before the age of 59½, they have to pay a tax penalty of 10 percent.
There are some limited exceptions to this tax penalty, including disability, death, or using the funds to make a first-time home purchase.
The great thing about a Roth IRA is that once an account is funded, investment gains accumulate tax-free as long as the owner follows the rules regarding withdrawals.
Roth IRAs vs. Other Types of Retirement Accounts
Besides a Roth IRA, an individual may have the option to invest in a traditional IRA, a 401(k) plan, or a standard brokerage account.
Standard Brokerage Accounts
Standard brokerage accounts are funded with post-tax income and do not get any special tax advantages. These accounts owe taxes on net realized capital gains on an annual basis.
The 401(k) account is a tax-advantaged account available only to employees of companies that sponsor a 401(k) plan. These accounts are funded with pre-tax income, which is income before the deduction for income taxes.
They have higher contribution limits than those of the Roth IRA account. A 401(k)-account owner is responsible for paying taxes on income and capital gains at the time funds are withdrawn and faces a penalty if funds are withdrawn before the age of 59½.
Finally, unlike a Roth IRA, which has significant investment flexibility, a 401(k) plan is limited to investment in a menu of options selected by the employer.
A traditional IRA is another type of individual retirement account. Traditional IRAs have similar eligibility requirements, but a different structure for delivering tax savings.
Like 401(k) accounts, traditional IRAs are funded with pre-tax income, and taxes are owed at the time funds are withdrawn. Funds withdrawn before the age of 59½ are hit with an additional tax penalty. Like a Roth IRA, traditional IRAs have significant flexibility for investment in a wide variety of stocks, bonds, and funds at the discretion of the account owner.
The table below summarizes the key differences between the Roth IRA and the traditional IRA.
A Roth IRA account taxes the account owner up-front and delivers tax savings later on. A traditional IRA account delivers an immediate tax benefit and defers the payment of taxes to withdrawals in retirement.
A good way to think about which account makes more sense to open is to determine when you will face higher tax rates. If you believe your tax rate will be higher in retirement, a Roth IRA may make more sense.
If you believe your tax rate will be lower in retirement, a traditional IRA may make more sense.