You don’t want to work forever. In fact, if you read this blog, there’s a good chance that you are planning on leaving traditional work behind earlier than most Americans. That means you’re on board with the idea of not just retiring, but retiring well. Opening a Roth IRA is an easy and essential way to do just that.
Here’s the basics of what you need to know about Roth IRA accounts and why you probably want to start contributing to one right away.
How is a Roth different from my other retirement accounts?
I know what you’re thinking: this is just another retirement account. But here’s the thing, a Roth IRA is truly different from other retirement plans.
For starters, IRA stands for individual retirement account. That means that this account is yours to control. Unlike your 401(k) or 403(b), a Roth IRA is not tied to your workplace or your employer. That means you get to choose the custodian and the investment options. If your employer sponsored plans are bloated with fees or don’t offer much by way of options, a Roth IRA can give you more freedom and more control over your money.
Another way that a Roth IRA differs from a 401(k) or a 403(b) is the roth aspect of the account. That means that your money grows tax free. Since you fund your account with after-tax income, when you withdraw money from your account in your golden years, you don’t have to pay federal taxes on that money.
Who can open a Roth IRA?
If it sounds like a Roth IRA is the right investment option for you, you’re probably wondering if you can actually open one. In order to open a Roth IRA, you need to earn an income. That’s it.
There’s no age requirement. Plus, it doesn’t matter if you work for a large corporation or if you’re a part-time freelancer. As long as you can prove that you’ve earned an income, you are eligible to fund a Roth IRA.
Of course, like all retirement accounts, there are some additional criteria to consider. To contribute to a Roth IRA, you:
Must earn an income (contribution totals cannot exceed your income)
Contribute up to $6,000 in 2021
Add an extra $1,000 if you’re 50 or older
Stay under the income limits
A Word About Roth IRA Income Limits for 2021
As with anything tax related, it is also important to consult Amount of Roth IRA Contributions That You Can Make For 2021. However, consider this a basic introduction to the income limits of a Roth IRA.
Contribution limits are based on an individual or couple’s adjusted group income (AGI) for the year. Depending on how much income you earn, you will find yourself in one of three situations:
You can contribute the full amount of $6,000 ($7,000 if you’re 50+)
You can make a reduced contribution
You are ineligible to contribute to a Roth that year
Let’s look at how this would play out for a couple who is married and filing jointly.
In order to make a full contribution, your adjusted gross income for the year has to be under $198,000. If your AGI is under $208,000, you can make a reduced contribution amount. In the event that your AGI exceeds $208,000 for the year, you are ineligible to make a Roth contribution.
What if I earn too much to contribute to a Roth IRA?
If your income exceeds the limits for making a Roth IRA contribution, congratulations! You have two reasons to celebrate. You should feel good about the fact that your income is so substantial, and you might also be able to make a backdoor Roth contribution.
The short version of it is this is a strategy that lets a high-income earner potentially contribute to a Roth IRA. The trick in this completely legal workaround is that it involves an account conversion first.
Essentially, you open a traditional IRA, fund it, and move the money into a Roth before the account has accumulated any earnings. Because of the pro-rata rule, it is possible that you’ll still be taxed.
Because this can be a complicated tax move, it’s best to really read up on it. There is an excellent step-by-step post from Physician on Fire and another post by Ramit Sethi that covers the nitty-gritty of it. Plus, it’s never a bad idea to consult with a tax professional.
How do I use my Roth IRA to invest?
One thing that some people misunderstand about a Roth IRA is that a Roth itself isn’t an investment. Instead, it’s a vehicle that holds your investments. So what does that mean?
You can open a Roth IRA with a bank or brokerage, and then you select what to invest in. Most people in FIRE are partial to index funds, but you do have other investment options as well.
Of course, you want to pay particular attention to fees. Paying even 1% in fees can take a considerable bite out of your returns over time. With several brokerages offering options that no-fee or next-to-no fee, it’s important to ask yourself why you’d pay high fees in the first place.
When can I access the money in my Roth IRA?
The whole point of this account is to grow your money. So now you’re probably wondering when you can actually get at those funds. Understanding how your can access the money in your Roth IRA reveals some real advantages of the account:
Tax-free distributions at 59.5
When you turn 59.5, you can access your distributions without paying federal taxes as long as you’ve held the account for five years. That’s one more great reason why you want to get this account opened pronto!
Contributions are yours anytime
If you find yourself needing to tap your funds, you can actually withdraw your contributions anytime without penalty. But that only applies to the contributions. Why? Because you’ve already paid taxes on the money you put into the account.
However, this should either be a carefully planned move or one made in a dire situation. Generally, it’s best to not touch your retirement savings until retirement.
Roth IRAs can be used for qualified college expenses. That’s why some people talk about using them to supplement a 529 or as an alternative to one. The catch is that you can take the money out without penalty, but you may still have to pay taxes on earnings.
No RMDs - pass it on!
Most retirement vehicles force people to take required minimum distributions (RMDs) by the time you are 70.5. However, Roth IRAs are not subject to them. That’s another way that Roth IRAs really give you freedom and control over your money.
Not only does this help with your retirement planning, it can also be a useful aspect of estate planning. A Roth IRA can help you build generational wealth, since it can be passed down. Of course, you’ll want to consult with an estate planning expert.
Final Thoughts on Roth IRA Accounts
No retirement option is perfect. But understanding the criteria and benefits of a Roth IRA is important. This investment option offers you more freedom and choice when it comes to your money. For many people, a Roth IRA is another tool you can use to plan the retirement you’ve been dreaming about.