What Is a Roth IRA? A Simple Explanation Even a 5-Year-Old Can Understand
This article was reviewed by Robin Hartill, CFP®.
If you’re confused when it comes to retirement savings, it’s OK. We’re going to talk about Roth IRAs, how they compare with other retirement accounts and how you can decide if a Roth IRA is right for you.
A Roth IRA could be a great option if you’re looking to supplement your employer-sponsored 401(k) — or if you don’t have one and need an alternative way to save for retirement.
What Is a Roth IRA?
A Roth IRA is an individual retirement account where you invest money you’ve already paid taxes on. Thanks to your contributions and compound earnings from returns, your money grows over time until you begin to withdraw it in retirement.
Why the name Roth? In 1989, two senators — Bob Packwood of Oregon and William Roth of Delaware — proposed the idea of this post-tax IRA. But it wasn’t until the passage of the Taxpayer Relief Act of 1997 that the idea came to fruition.
Unlike a 401(k), an IRA — whether it’s a Roth or traditional IRA — is an account you open on your own. It’s not affiliated with an employer.
What makes a Roth IRA unique is how the government taxes it.
With a traditional 401(k), you put your money into the account before taxes are taken out. With a traditional IRA, your contributions are after-tax but you can often deduct them. With both of these plans, you’ll pay taxes on your contributions and earnings at the time of withdrawal.
But with a Roth IRA, you’re investing money after you pay taxes on it and it’s not deductible. So when you reach age 59 ½, the Roth IRA rules let you withdraw all of it — your contributions and earnings — tax-free.
8 Benefits of a Roth IRA
Opening a Roth IRA has multiple advantages, including:
1. It’s a Tax-Free Source of Income in Retirement
Because you’re paying taxes upfront, a Roth IRA is a good option if you expect to make significantly more money in the future. You’ll probably be taxed in a lower tax bracket now than you would be if your earnings are higher later on. On the other hand, many retirees live on a fixed income, so avoiding taxes could help out more than you think.
2. You Can Withdraw Your Roth IRA Contributions at Any Time
Because you’ve already paid taxes on your Roth IRA contributions, you can withdraw those tax-free whenever you need them.
However, if you withdraw from your earnings before you reach 59 ½, you’ll have to pay income tax on them, plus a 10% penalty.
3. You Don’t Have to Take Money Out
With a traditional IRA or 401(k), you’re required to take out a certain amount — known as a required minimum distribution (RMD) — once you reach age 70 1/2. The amount you’re required to withdraw depends on your age, your life expectancy and how much you have in your account.
But you’ll never have to take money out of your own Roth IRA. A Roth IRA has no RMDs while you’re still alive, though when you die, your account beneficiary may have to take them.
4. It’s an Option for People Who Don’t Have a 401(k)
You need earned income — such as a salary, hourly wages, bonuses, tips or self-employment income — to contribute to a Roth or traditional IRA. But because you open an IRA on your own, it’s a good way to save for retirement if you’re self-employed or your employer doesn’t offer a retirement plan. You can also use it to supplement your employer-provided plan.
If you have a 401(k) and want to invest money you’ve already paid taxes on, ask if your employer offers a Roth 401(k). You also fund these accounts with after-tax dollars and later withdraw your money tax-free in retirement.
5. You Can Use a Roth IRA for a First-Time Home Purchase
You can withdraw up to $10,000 worth of earnings ($20,000 for married couples) from your Roth IRA penalty-free to help pay for a first-time home purchase if you’ve had the account for five years or more. The IRS usually considers you a first-time homebuyer if you haven’t owned a home in the past two years, though the $10,000 limit is for your lifetime.
6. … or College Expenses
You can withdraw earnings penalty-free if you use the funds to pay for college or other higher education — for yourself, your child or your spouse. You’ll still owe income taxes on the earnings, though.
7. It Offers a Safety Net
You might be able to use Roth IRA funds to pay for medical expenses that exceed 7.5% of your adjusted gross income in 2020, or to pay for your health insurance premiums if you’ve claimed unemployment compensation for more than 12 consecutive weeks.
If you become permanently disabled, you can also use the money from your Roth IRA to help with your expenses.
8. There Are No Age Limits
With a traditional IRA, you can’t make contributions once you reach age 70 ½, but there is no age limit for contributing to a Roth IRA.
4 Disadvantages of a Roth IRA
While there are many benefits to opening a Roth IRA, there are also some disadvantages to consider. Here are a few.
1. You Don’t Get an Upfront Tax Break
Unlike a traditional IRA, a Roth IRA doesn’t reduce your taxable income, so you wind up paying more in taxes now. Your tax break comes when you reach retirement age.
2. You Can Only Contribute $6,000 a Year if You’re Under 50
The 2020 Roth IRA limit on contributions is $6,000 — in a Roth, traditional or both. If you choose a traditional and a Roth IRA, your contribution limit is $6,000 total, so it’s up to you to decide how to distribute that money between your accounts.
That limit goes up to $7,000 once you’re 50 or older, allowing you to contribute faster to your retirement fund.
3. You Can’t Contribute to a Roth IRA if Your Income Is Too High
The IRS adjusts the income requirements each year. For tax year 2020, you must make less than $124,000 annually as a single tax filer to contribute the full amount. From there, the amount you can contribute phases out. If you make more than $139,000, you aren’t eligible to contribute to a Roth IRA.
If you are married filing jointly, your contribution limit starts to go down if your combined income is over $196,000, and you’re ineligible if your income is over $206,000.
4. You Have to Set It Up on Your Own
Unlike a 401(k), which your employer sets up for you, a Roth IRA is an account you open on your own, so you have to do your own research about what to invest in or get help from a financial adviser.
How to Open a Roth IRA
If you’ve decided to open a Roth IRA, you’ll first need to pick a provider. The table below lists some popular ones, as well as what they charge for commissions and their account minimums. Other providers with account minimums are less accessible for savers who are just starting out and don’t have a lump sum to add to their IRA.
|Vanguard||$2-$20 per trade||$0|
|Charles Schwab||$4.95 per trade||$0|
|Fidelity||$4.95 per trade||$0|
|TD Ameritrade||$6.95 per trade||$0|
|Ally Invest||$4.95 per trade||$0|
Once you’ve chosen a provider, you can easily open an account online. Be ready to provide information like your birthdate and your Social Security number. Then, you’ll need to determine how and where you want to invest your money.
If you’re a savvy investor, you can manage your own IRA and choose exactly where your money is going. But if you have no idea what you’re doing, you can choose an automated robo-adviser to invest your money for you. Typical fees range from 0.25% to 0.5% of your account balance.
The types of investments your robo-adviser makes will largely depend on your age and risk tolerance. In general, a robo-adviser will make riskier investments in stocks for younger customers and will shift to more conservative investments as you get closer to retirement age.
Once you’ve invested your money, keep contributing more. Max out your annual contribution whenever possible. Sometimes your investments will make you money; sometimes they will lose you money. The idea is that over the long period of time you own the account, your money will grow to a nice little nest egg.
Catherine Hiles lives in Ohio with her husband and their two children. By day, she manages a team of writers and graphic designers, and catches up on her own writing in her spare time.