Is a Roth IRA right for you?
When selecting an IRA, the tax bracket you’ll fall into once you’ve retired factors in. With Roth IRAs, there are a few additional things to consider. What will your investments be? How about assets and stocks? Will your taxes likely be higher in retirement? If the answer is yes, a Roth IRA may be the best option.
A Roth IRA is ideal for someone who will have higher taxes following retirement. There are some key reasons for this. Here’s what to know about Roth IRAs.
What is a Roth IRA?
A Roth IRA is a special individual retirement account. It’s an account that permits qualified withdrawals on a tax-free basis as long as certain conditions are met. If you qualify, you can establish a Roth IRA account any time you’re ready and at any age.
It’s easy to find out if you’re eligible for a Roth IRA. Firstly, only those with earned income qualify for a Roth IRA. And it’s not possible to deposit more than you earned. Not only must you have an earned income to qualify for a Roth IRA, but there’s an income limit for Roth IRA eligibility.
Where you establish your account must also meet certain criteria. You must establish a Roth IRA with an IRS-approved institution. Check your nearby banks, brokerage companies, and federal credit unions. Most of these meet the criteria.
By now, you might be wondering if Roth IRAs are similar to traditional IRAs. The answer is yes. But there’s a key distinction that makes Roth IRAs more appealing to some.
Roth IRA Versus Traditional IRA
The primary difference between a Roth IRA and Traditional IRA comes down to tax advantages.
As noted by Investopedia, you fund Roth IRAs with after-tax dollars; the contributions are not tax-deductible. Once you start withdrawing those funds, the money is completely tax-free and will remain tax-free. You fund traditional IRAs with pretax dollars. Those using this type of IRA usually receive a tax deduction based on their contribution. In other words, traditional IRAs require paying income tax when withdrawing money from the retirement account and Roth IRAs do not.
Traditional IRAs are a lot like personalized pensions. Roth IRAs are special retirement accounts that work more like regular investment accounts. And so, you only pay taxes on the money going in. The difference with a Roth IRA for those who qualify is that, unlike a typical investment account, all future withdrawals are totally tax-free.
If you’re not sure which one is right for you or see benefits in both, you may not have to choose between them. It’s possible to qualify for both a Roth IRA and a traditional IRA. For those that are eligible for both types, you can own and fund your different IRAs at once. However, your total deposit amount cannot exceed the overall IRA contribution limit assigned to that tax year. While taxed differently, traditional IRAs and Roth IRAs have the same contribution limits.
So be sure to do the math.
Contributing to a Roth IRA
No matter how you go about it, make your contributions for a tax year by your specific tax-filing deadline. As noted, there’s a limit to how much you can contribute to a Roth IRA. In fact, the IRS limits how much can go into any type of IRA and the allotted amounts change from time to time.
One thing that will not change with a Roth IRA is what you are allowed to contribute. All Roth IRA contributions must be made in cash. And yes, that includes checks. While you can’t contribute assets directly, there are a variety of investment options available once your cash funds have been safely contributed into your Roth IRA. Some options include mutual funds, stocks, bonds, ETFs, and money market funds.
If you’ve been contributing to your Roth IRA for a while, you may also be eligible to withdraw your funds prior to retirement. But there are some other criteria you’ll have to meet.
Withdrawing Your Earnings Early
If you wish to withdraw earnings before retirement, you can avoid taxes (and the 10 percent early withdrawal penalty) if your Roth IRA has been an active account for at least five years. Your eligibility will come down to whether or not at least one of the following circumstances applies to you.
- Age. Those who are at least 59 ½ years old qualify for early withdraws.
- Those with a permanent disability may qualify as well.
- In the event of death, your beneficiary or estate can withdraw the funds from your Roth IRA.
- Planning to buy a home for the first time? You may be eligible to use the funds from your Roth IRA for a first-time home purchase.
Whether you qualify for early withdrawal or not, anyone with a Roth IRA can maximize the funds in their account. You’ll get the most out of your Roth IRA by starting early. The longer you have your Roth account, the more it can grow. Here’s what else to know about maximizing your account.
How to Maximize Your Roth IRA
Even if you can’t contribute the maximum amount, you should contribute as much as you’re able, and do so consistently. Consider making contributions as early in the tax year as you can. And definitely don’t wait until right before tax season is over. Because the money is tax-free, you’ll get better compounding effects in the long run if you get ahead of it.
Financial experts advise making Roth IRA contributions at the start of the tax year, giving those funds as much time as possible to “snowball”. If you’re unable to budget for this type of contribution, it is also beneficial to make small, equal deposits on a monthly basis. You’ll still benefit greatly this way. Also, if you happen to hold stocks in your Roth IRA, the monthly route (aka dollar-cost averaging) may work out better in the end.
Consider your investments as well. Mutual funds are the most common and popular form of IRA investments. When aiming to maximize your funds, mutual funds are one of the easiest ways to go about it. They also offer more diversification. While trickier to manage, investing in stocks can also yield higher returns.
For those with an exiting traditional IRA, there’s another possible way to maximize your Roth IRA.
Consider IRA Conversion
If you currently make “too much” money, you won’t be allowed to contribute those earnings to a Roth IRA. Or, how much you’re allowed to contribute will be limited. Although, there are exceptions to this rule. Some high earners are eligible to bypass these income limits through non-deductible contributions that go into a traditional IRA and then are quickly converted to a Roth IRA.
No matter how much you make, conversion is something to consider to get the most out of your Roth IRA. If you already have (or plan on opening) a traditional IRA, look into converting it to a Roth IRA at some point. The benefit? Income eligibilities and restrictions don’t apply to conversions. Even if you make more than the required income, IRA conversion can be a way to still reap the benefits of a Roth that might otherwise be out of reach. With that said, income taxes will still be in place the year you make the big switch, and it could be quite costly.
So look at all the numbers closely before converting your account to figure out what’s really worth what.
Be Prepared For Roth IRA Fees
No matter how much you put into your account, you need to know what’s coming out. While Roth IRAs can produce many benefits, they can also cut into your money significantly if you’re not careful. Avoid hidden fees by covering all bases. And know the basic fees too.
For instance, when setting up your Roth IRA, make sure to name a beneficiary. Without a beneficiary, the funds from your retirement account may be subject to probate fees. Not naming a beneficiary will also make you more vulnerable to existing and future creditors.
Remember, what sets a Roth IRA apart is that there’s no tax break up front and tax-free withdrawals. But a tiny difference in mandatory fees can greatly impact that balance over time. The primary types relate to Roth IRA account maintenance, transaction fees, commissions, and fees typically associated with mutual funds (expense ratios.)
In turn, you really want to choose your provider wisely. Comparing fees between providers before making a final decision could save you from unwittingly losing a significant chunk of the money you thought you were putting aside for retirement. Once you’ve selected your provider, keep a close watch on the fees over time. Make sure you’re not losing more than you stand to gain, and if you are, it might be time to move some money around.
And when in doubt or starting out, consult a financial advisor to walk you through it.
Start Your Roth IRA Today
While there are some potential downsides, a Roth IRA is one of the best ways to save for retirement. A Roth is especially useful when putting aside the money you might want to be more adventurous with someday. The key is to set up your account wisely. Keep up with fees, work with a financial advisor, and divide your funds accordingly. Most importantly, get started now.
There’s no time like the present to start building your nest egg. If your retirement is a long way off, you could potentially wind up with decades of untaxed earnings and withdraws. As mentioned, the tax-free money in your Roth IRA will accumulate the longer it sits in the account. You can open a Roth IRA at any age and experts say the younger you get going, the better off you will be.
If you qualify, perhaps it’s time to start planning for a more comfortable tomorrow and establish your Roth IRA today. You’ll thank yourself later.