In our last post, we took a close look at Traditional IRAs – a type of retirement account that allows you to make tax-deductible contributions at any age, so long as you have earned income. However, not everyone benefits from this type of account. If you’re anything like me – a millennial, semi-recent college graduate in a pretty low tax bracket, there is actually a retirement account that could work much better for you. It’s called a Roth IRA.
So, what exactly is a Roth IRA, and how does it differ from a Traditional IRA? Where Traditional IRAs offer tax-deferred growth, Roth IRAs actually grow tax-free. This is because you pay taxes on the contribution to the account up front. When you decide to withdraw the funds, the withdrawals will be tax-free so long as you meet certain criteria.
Much like a Traditional IRA, you need to have earned income to open and contribute to a Roth IRA. You can have earned income at any age, but minors with jobs may need to open what is called a “custodial account”.
Your earned income also determines your eligibility to contribute to a Roth IRA. For example, if you are single and make less than $125,000 per year, you are able to make the maximum contribution of $6,000 to your Roth for this current year. If you are married filing jointly, your combined income must be less than $198,000 in order to contribute the maximum of $6,000 to your Roth. If your yearly income is higher that $140,000 for singles, or $208,000 for married filing jointly, you are unable to contribute to a Roth IRA. You should be aware that these limits change yearly, so it is important to check on the guidelines for the year you are contributing to ensure you still fall within this threshold.
It is also important to note that while anyone of any age with earned income can contribute to a Roth IRA, an individual’s yearly contribution cannot be greater than his or her income. So, if you only make $4,000 per year, you cannot contribute the maximum $6,000 to your Roth. However, spouses can contribute to each other’s Roth accounts if one spouse earns more than the other.
You have until April 15th of the following year to make contributions to a Roth. For example, you can make a 2021 Roth IRA contribution on April 1st of 2022.
Roth IRA Positives
When you contribute to a Roth IRA, you are creating savings for your future. You will pay the taxes now, so that you can withdraw the money tax-free later.
Generally, there are no tax deductions associated with these accounts. However, some contributors may be eligible for what is known as a Saver’s credit. You can check with your tax preparer to see if you qualify for this benefit.
Roth IRAs are also nice because you can withdraw your contributions at any age without penalty. You can withdraw your earnings without a penalty starting at age 59 ½, so long as you have owned the account for at least five years.
Things to Keep in Mind
You will want to be aware of the rules for withdrawals so that you do not end up owing a penalty. If you are under 59 ½ and have owned your account for at least 5 years, earnings are subject to taxes and a 10% penalty unless the money is used for one of a few specific exceptions, such as a first-time home purchase or a permanent disability.
If you are under 59 ½ and have owned your account for less than 5 years, your earnings will be subject to taxes and a 10% penalty unless used for one of a few specific exceptions.
If you are 59 ½ or older and have owned your accounts for less than 5 years, your earnings will be subject to taxes, but not the 10% penalty.
Who Benefits Most from a Roth IRA?
Roth IRAs can be very beneficial to young people who are just beginning to save. So long as you are making enough to contribute, it could be better to pay the taxes now, while you are in a lower tax bracket, then withdraw the money tax-free when you are older and your tax-bracket will likely be higher.
SO, HOW DO YOU KNOW IF A ROTH IRA IS RIGHT FOR YOU?
When it comes to retirement planning, there is no “one size fits all”. It can be hard to know which types of accounts make the most sense for your unique financial situation. If, after reading this article, you still have questions about retirement accounts, you may want to consider working with a fiduciary financial advisor, who is legally required to work in your best interest.