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What Is a Roth IRA and How to Open a Roth IRA Account Need help figuring out what a Roth IRA is, how it works or how to start one? Discover the answer to these questions and more in this detailed guide.

By Entrepreneur Staff

When it comes to retirement, saving sooner is better than saving later. But if you've already maxed out your 401(k) or don't have the option to use a 401(k), you'll have to turn to an IRA or individual retirement account.

Traditional IRAs are just one of your options, however. You can instead put money into a Roth IRA. Financial advisors can help you navigate the ins and outs; however, knowing about Roth IRA withdrawal restrictions and annual contribution limits is essential before investing in this type of account.

This article will explain a Roth IRA, how it works and how you can start one at the earliest opportunity.

Related: When converting from an IRA to a Roth, do I have to file self-employment tax?

What is a Roth IRA?

A Roth IRA is a type of individual retirement account. As a tax-advantaged individual retirement account, Roth IRAs allow you to contribute after-tax dollars. The best way to understand a Roth IRA is to compare it to a traditional IRA.

A traditional IRA is a tax-deferred account. You contribute money to a regular IRA pre-tax, so you don't have to pay income taxes on any of those contributions (lowering your gross income).

You can deduct contributions from your IRA each tax year. However, when you withdraw money from your regular IRA, you must pay taxes on those withdrawals since they are no longer tax-deductible.

A Roth IRA is the opposite. You contribute money to the Roth IRA and are taxed on those contributions, just like the rest of your regular income.

However, since that money is taxable income, you don't owe any taxes when you withdraw money from your Roth IRA. You walk away with more money in Roth IRA income than traditional IRAs.

You can still only take penalty-free withdrawals (or qualified distributions) after you are 59 1/2 years old, according to the SIPC. Still, Roth IRAs are excellent for securing tax-free income when you're older, regardless of filing status. Roth IRAs are also FDIC-insured in most cases, usually up to $250,000.

Roth IRAs are primarily advantageous if you think you'll be in a higher tax bracket when you withdraw your money (which is true for many Americans). For instance, if you don't have much money in your 20s and 30s but earn much more in your 60s, you'll have to pay more taxes on your withdrawals if you use a traditional IRA.

A Roth IRA allows you to circumvent this downside and have more retirement savings for your golden years. Thus, opening a Roth IRA at a trusted brokerage could be a great way to enjoy tax-free growth of your savings.

What's the difference between a Roth IRA and annuities?

When planning for retirement, two options often come into consideration: Roth IRAs and annuities. While both can provide substantial income for your golden years, they differ significantly in their mechanics and tax implications.

Annuities are insurance products that provide a steady stream of income in retirement. Typically, an individual pays premiums to an insurance company over time. Once the person retires, the company begins paying out an agreed-upon amount.

The annuity payments continue for a predetermined period, which could be a certain number of years or the remainder of the annuitant's life. The exact amount received usually depends on the premium amount, the age of the annuitant at retirement, and the specific terms of the contract.

Unlike Roth IRAs, annuity payments are considered ordinary income and are subject to income tax. The portion of the payment that represents the return of the premiums paid is usually tax-free. However, any earnings on those premiums are taxable. Thus, depending on an individual's tax bracket in retirement, annuities could lead to a higher tax bill compared to a Roth IRA.

On the other hand, a Roth IRA functions differently. Savers contribute post-tax income to a Roth IRA, meaning that the money has already been taxed as ordinary income. Thus, when it comes time to withdraw, both the contributions and the earnings are tax-free, providing that certain conditions are met. Tax-free withdrawals can be a significant advantage, particularly for those who expect to be in a higher tax bracket in retirement.

Can you combine a Roth IRA with other options?

Many savers consider having a diverse retirement portfolio, utilizing various financial vehicles. This strategy allows taxpayers to adapt to changing financial circumstances and tax laws. For many, a Roth IRA could be one part of this strategy.

In addition to Roth IRAs, many people also have 401(k) plans, which are often provided by employers. While Roth IRAs have post-tax contributions and tax-free withdrawals, traditional 401(k)s have pre-tax contributions and taxable withdrawals.

There are also Roth 401(k) options that blend the features of both – they have post-tax contributions like a Roth IRA, but they also have the high contribution limits of a traditional 401(k).

This combination can give savers greater flexibility. By having both Roth and traditional retirement accounts, savers can strategize their withdrawals to minimize their tax burden. For example, in a year when other income is high, savers might take more from a Roth account to avoid moving into a higher tax bracket.

How does a Roth IRA work?

A Roth IRA works very similarly to a traditional IRA. You sign up for a Roth IRA account at a financing institution, like Fidelity or Vanguard, and regularly contribute to the account.

Depending on your preferences, you can select your investments individually or have a fund manager take care of them. You can find a Roth IRA from many different financial sources, including:

  • Regular or standard contributions
  • Spouse IRA contributions
  • Transfers from other accounts
  • Conversions
  • Rollover contributions

You have access to many different investment options through a Roth IRA, even if you do a Roth IRA conversion from another account.

Note that all standard Roth IRA contributions have to be made in cash. Therefore, you can't contribute money to your Roth IRA in the form of property or securities; you have to report those contributions, so they're taxed according to your tax rate.

Just like regular IRAs, Roth IRA investments grow tax-free. Notably, Roth IRAs are much less restrictive compared to other retirement accounts. You can maintain your Roth IRA indefinitely, and unlike traditional IRAs, there aren't any required minimum distributions (RMDs).

The early withdrawal penalty for this type of IRA is the same as with a standard IRA, even if you have a brokerage account handle it.

Related: Do You Know the Difference Between a Traditional IRA, a Roth IRA, and a 401k?

Are Roth IRAs insured?

It depends. If your Roth IRA is at a bank, it may be classified under a separate insurance category compared to regular deposit accounts. Because of this, insurance coverage for most IRA accounts isn't as comprehensive or robust.

That said, the Federal Deposit Insurance Corp. (or FDIC) does provide insurance protection worth up to $250,000 for both traditional and Roth IRAs. Note that account balances are combined instead of protected individually, however.

Contribution rules for Roth IRAs

Roth IRAs, like other IRAs and retirement accounts like 401(k)s, have contribution limits. Roth IRA contribution limits prevent account holders from investing too much money into their accounts at once.

For instance, in 2023, the total yearly contribution you can make to a Roth IRA is $6500 if you are under 50. If you are 50 or older, you can contribute another $1500 to your account as a catch-up contribution.

Withdrawing from a Roth IRA

Just like a traditional IRA, Roth IRAs have specific rules around withdrawals. Specifically, you cannot withdraw any earnings from your Roth IRA without incurring fees unless you are 59 ½ or older.

Note that that's not the same thing as contributions; you can withdraw contributions (such as the original amount of money you put into the account) at any point. This earnings withdrawal limit prevents people from using their Roth IRA as a traditional investment or stock trading account.

Since most people retire around 59 ½, the government charges a 10% penalty and other taxation fees if you withdraw any earnings or gain money from your Roth IRA early.

In addition, there's a "five-year rule" to keep in mind. If you start your Roth IRA late in life, you can withdraw your earnings tax-free only if you withdraw that money five years after your first contribution to any Roth IRA under your name.

The five-year time clock begins with your first contribution to any Roth IRA, not just the one from which you want to withdraw funds.

Of course, there are some exceptions to these rules. You could avoid the 10% taxation and penalty rate if you use the earnings from your Roth IRA to buy a home for the first time. But in this case, you can only take out $10,000.

Furthermore, if you have a permanent disability or pass away, you or your beneficiary can take money out of your Roth IRA.

Bottom line: Try to plan that won't be withdrawing money from your Roth IRA until you retire.

Related: Should I Use a Roth IRA to Pay for College?

What are the tax implications of a Roth IRA?

One significant advantage of Roth IRAs is their tax benefits. Unlike other forms of retirement savings, Roth IRA contributions are made with post-tax dollars. This means that when taxpayers file their tax return, they won't get a tax deduction for the contributions made. However, this initial lack of tax relief comes with a substantial future benefit: tax-free withdrawals in retirement.

This contrasts with traditional IRAs or 401(k)s, where contributions reduce your taxable income in the year they are made, but withdrawals are taxed as ordinary income. With a Roth IRA, although you miss out on the upfront tax break, you secure tax-free income for your future.

Moreover, the tax-free nature of Roth IRA withdrawals means they do not contribute to your taxable income in retirement. This can have numerous advantages, such as potentially lowering the tax on Social Security benefits or reducing Medicare premiums, which can be influenced by your income level in retirement.

What can you invest in with a Roth IRA?

Once you open a Roth IRA, you can invest in a wide range of funds, stocks, assets and other investments. You can invest in the following:

  • Stocks
  • Mutual funds
  • Bonds
  • Exchange-traded funds or ETFs
  • Certificates of deposit or CDs
  • Money market funds
  • Cryptocurrencies, but remember that the IRS does not let you contribute cryptocurrency directly to your Roth IRA (unless you use a new type of Bitcoin IRA)

Related: Best Retirement Plans – Broken Down By Rankings

What are the benefits of Roth IRAs?

Many people open Roth IRAs in conjunction with a 401(k) or instead of traditional IRAs, as the benefits of a Roth IRA can include the following:

  • No minimum distributions are required: You don't have to contribute a certain amount each year when you have a Roth IRA.
  • No income tax for inherited Roth IRAs: Therefore, if you pass your Roth IRA to an error or beneficiary, they can also get tax-free withdrawals (provided that you meet the five-year rule).
  • Easier withdrawals: With a Roth IRA, you can withdraw any contribution money without taxes or penalties (though you may face penalties if you withdraw investment earnings before the age of 59 ½).
  • Flexible contribution schedules: You can decide how much you contribute to a Roth IRA and when.
  • Plenty of time to add contributions: You have until the tax deadline each year to contribute more money into your Roth IRA to reach the $6500 limit.
  • Extra savings for retirement: You can combine your Roth IRA contributions with a 401(k) retirement plan.
  • Tax-free distributions: After you've held your Roth IRA for five years and are 59 ½ years old, you can take any distributions, including investment earnings, from your Roth IRA without paying federal taxes.
  • Open at any age: Anyone can open a Roth IRA at any age, provided they have earned income.
  • Education expenses. The IRS allows penalty-free withdrawals for qualified higher education expenses, including tuition, fees, books and room and board for you, your spouse, your children, or grandchildren. While these withdrawals may still be subject to income tax, they avoid the usual 10% early withdrawal penalty.
  • Home purchases. First-time homebuyers can withdraw up to $10,000 from their Roth IRA contributions and earnings penalty-free to put towards the purchase and down payment.

How can you start a Roth IRA?

Knowing how to start one for yourself and your retirement future is essential, given the benefits and importance of a Roth IRA.

Check eligibility

Your first step is ensuring you are eligible to open a Roth IRA account. Note that you must have earned some income for the current tax year — this does not include any inheritance money you may have received from others.

Furthermore, income limits may prevent you from opening a Roth IRA. For instance, in the 2023 tax year, the income "phase-out" range (the income bracket allowed to make reduced contributions) is $138,000 and $153,000 as an individual or $218,000-$228,000 for couples who are married filing jointly.

In addition to basic eligibility rules, your ability to contribute to a Roth IRA is determined by your Modified Adjusted Gross Income (MAGI) and Adjusted Gross Income (AGI).

Both MAGI and AGI are measurements of your income that are used by the IRS to determine your eligibility for certain tax benefits:

  • AGI is calculated by subtracting certain adjustments from your total income. These adjustments may include student loan interest, contributions to a traditional IRA, and alimony payments, among others.
  • Your MAGI, on the other hand, is calculated by adding certain deductions and tax breaks back into your AGI, like foreign earned income and tax-exempt interest. If your MAGI exceeds certain limits, you may not be able to contribute the maximum amount to your Roth IRA, or you may not be able to contribute at all.

For those who are not eligible to contribute to a Roth IRA due to high income, there is a workaround known as a "Backdoor Roth IRA." For this option, you would contribute to a traditional IRA and then convert that contribution into a Roth IRA. There are no income limits to this method which makes it a viable option for high earners.

However, there are tax implications to consider, so it's important to consult with a tax advisor before proceeding.

Remember, too, that there are limits on how much you can invest into your Roth IRA each year.

Related: Learn How to Invest Beyond Stocks, FDs, Property And Gold

Find an investment platform

Your next step is finding the right investment platform to open a Roth IRA. Practically every stock investment company offers Roth IRA accounts. If you already have a 401(k) or traditional IRA account, you can open a Roth IRA at the same organization, which may be easier than finding another organization.

Regardless, if you find a good platform or financial institution, ask questions like:

  • Whether there are fees to open or maintain your account (such as annual fees).
  • What kind of customer service the company provides.
  • What types of investments the company offers for your Roth IRA.
  • Whether it costs money to trade with your IRA, which could be important if you plan to buy and sell stocks or securities with your account.

Examples of institutions that offer Roth IRAs include Fidelity Investments, Vanguard and Charles Schwab.

Apply for a Roth IRA

Now it's time to complete the necessary paperwork and apply for a Roth IRA. You can usually do this online or in person if there's a local branch of your financial institution nearby.

In any case, you'll need a few pieces of key information to complete the process:

  • Your Social Security number or SSN.
  • Your driver's license or some other type of photo ID.
  • The bank routing number and checking or savings account number that you want to use to contribute money to your account.
  • The name and address of your employer.
  • The name, address and Social Security number for your plan beneficiary; this is the person who can receive money in your Roth IRA if you die.

Choose your investments

After opening your Roth IRA, you get to pick your investments. Most financial institutions have advisors to help you choose suitable investments for your portfolio based on your goals.

For instance, if you want to grow your Roth IRA slowly but surely, your investment advisor may recommend that you choose safe investments.

If, on the other hand, you are young and looking to save aggressively, they may recommend more aggressive, risky investments since you have time to make up for any lost income.

Because many people live longer than before, it may be wise to keep many stocks in your portfolio as you age. Since you live longer, it could be wise to continue holding assets in your Roth IRA even after you retire so you can continue making money to pull from.

Related: Roth IRA - Entrepreneur Small Business Encyclopedia

Make contributions

Now, you have to make regular contributions to your Roth IRA. Remember, there are no limits on when you can make contributions; you just have to contribute up to the limit to maximize your portfolio's growth.

As you can see, there's a lot to like about Roth IRAs, and getting one started is just as easy as starting a traditional IRA. Consider your options carefully before contributing to any retirement account, as the penalty for withdrawing ahead of retirement can make switching your plans more costly than you think.

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Entrepreneur Staff

Entrepreneur Staff


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