• Stephanie

So What's a Roth IRA Anyway?

Updated: Oct 5, 2020

You finally decide to take the plunge and start investing. Maybe you start with your employer-sponsored 401K, or maybe you're still trying to figure out your options and have heard good things about this "Roth IRA" thing and want to learn more. Well you've come to the right place!

If you haven't read it yet, checkout our post on IRA basics. It gives you an easy to understand overview of what an IRA is and how you can use one to build wealth.

So, what is a Roth IRA?

In short, a Roth IRA is a tax advantaged retirement account in which you, as the account holder, can make "post-tax" (taxes have already been paid via your income/payroll taxes) contributions in order to save for retirement. All contributions (investments) then grow tax free. When you are ready to withdraw from the account, you would owe no additional taxes on neither the contributions nor the growth (i.e. withdrawals are 100% tax free!).

Sounds great, what's the catch?

As with all U.S. retirement plans and accounts, there are rules around how much you can contribute, who can contribute, and when.

How Much:

For 2020, the annual contribution limit for a Roth IRA is $6,000. If you are 50 or older, the IRS allows an additional $1,000, making it a maximum contribution of $7,000.

Who Can Contribute:

As with all IRAs, the IRS requires that any individual contributing to an IRA (Traditional or otherwise) must have earned income (e.g. W-2 income, contractor, tips, etc…) equal to or greater than their contribution amount.

  • That means that if you want to contribute $6,000 to an IRA in 2020, you must have at least $6,000 in earned income reported on your 2020 tax return.

When You Can Contribute:

Also as with all IRAs, the contribution window for a given year runs from January 1st through Tax Day (typically April 15th) the following year. That's right, 15 ½ whole months to save your tax-free heart out!

Additionally, Roth IRAs have an income limit for who can contribute based on your tax filing status, as well as restrictions on how much you can contribute. The limit is based on your MAGI (Modified Adjusted Gross Income), which in most cases, can be estimated based on the MAGI from your previous year’s AGI (Adjusted Gross Income), found on line 8b of your 1040 Federal Tax Form.

For 2020, to qualify for a Roth IRA contribution you must meet the following requirements:

So what makes a Roth IRA so special?

Roth accounts (IRAs, 401Ks, 403b's, etc…) are the only retirement savings and investment accounts which you can not only grow your investments 100% tax free, but then withdraw the money 100% tax free! The only taxes paid are those that come out of your paycheck (and/or when you file your income taxes).

With a Roth IRA, you don't have to worry about what your future tax bracket will be or even what future income taxes will be at all!

There are also no required minimum distributions (RMDs) during the account holder's lifetime. You can maintain the Roth IRA indefinitely, and choose to never pull funds from it. Some people do this as a way to leave something for their loved ones or to establish generational wealth.

Additionally, Roth IRAs are one of the only retirement accounts which allow you to withdraw the principal contributions prior to retirement age (59 ½) without penalty. What does that mean?

Let's say you're 30 years old and contribute $20,000 to your Roth IRA over the course of 5 years. Your contributions are invested in a low cost index fund that tracks the S&P 500, and the market has been good over those 5 years, so your balance is now $30,000. So that's $20,000 in principal contributions and $10,000 in unrealized gains.

Now you're 35, and let's say you have a major emergency that occurs and for whatever reason, you can't use your emergency fund (maybe it's been depleted or you didn't follow our advice and set one up in the first place...tsk tsk…).

Anyway, you need to pay for the emergency, and with the Roth IRA you now have $20,000 of tax-free (though really post-tax) funds accessible to you. You can withdraw up to that $20,000 without any penalties or additional taxes due. Additionally, the withdrawn funds do not impact your adjusted gross income when you file your taxes for that year.

Now certainly, we don't encourage you to raid your retirement accounts, but in extreme circumstances, a Roth IRA can be a lifesaver.

I have a 401K/403b/457b and/or a Traditional IRA. Can I still have a Roth?

So you've learned about what a Roth IRA is, figured out that you qualify, but aren't sure if you can contribute because you already have an employer sponsored retirement account and/or a Traditional IRA?

The great news is that you may still be able to contribute to a Roth IRA! So long as you meet the contribution qualifications above, you can contribute to any of those other employer-sponsored retirement plans, as well as a Traditional IRA.

Where can I open a Roth IRA?

The great news is that almost all brokerage firms, investment/financial service companies, roboadvisors, and many banks offer a Roth IRA. Some very popular firms are Vanguard, Fidelity, Charles Schwab, and Betterment.

The rules around Roth IRAs are the same across all firms, so some of the things to look for are:

  1. Investment fund options

  2. Expense Ratios and Fees

  3. Ease of use

  4. Customer Service

Note: If you open an IRA with one firm and start making contributions for a given year, then rollover the funds mid-year to another firm's IRA, you will be responsible for keeping track of how much you contributed to each IRA to ensure you do not exceed the annual contribution limit. The new IRA firm will not know how much you have already contributed for the contribution year (January 1st to April 15th following year). Rolled over contributions (e.g. Roth 401K to Roth IRA or Roth IRA @ Brokerage #1 to Roth IRA @ Brokerage #2) do not count towards your annual contributions.

So you've made it this far, and may now be wondering "What does Roth mean"?

Here's a little history lesson for my fellow money nerds 🤓. Don't worry, it will be short, but informative. In 1997, while many of us were gettin' jiggy with Will Smith or watching Titanic in the theater for the 4th time, a senator in Delaware named William Roth was seeing almost 9 years of hard work and legislation come to fruition.

Jack (Leonardo DiCaprio) and Rose (Kate Winslet) standing on the port of the ship in Titanic
Jack, I think I want to max out my Roth contributions!

Back in 1989, Senator Bob Packwood of Oregon and Senator William Roth proposed what was then called an "IRA Plus" which would have allowed individuals to invest up to $2,000 in an account with no immediate tax deductions, but the earnings could later be withdrawn tax-free after retirement age (59 ½).

Roth understood the retirement savings crisis facing Americans and wanted to try and reverse it. And so, the Taxpayer Relief Act of 1997 was established, along with the Roth IRA, named for its chief legislative sponsor, Senator William Roth.

So there you have it. Everything you need to know about the basics of a Roth IRA. There are so many great options you can do with a Roth IRA to set yourself up for a successful retirement, early or otherwise.

Still have questions about Roth IRAs? Ask us in the comments below, send us an email, or slide into our DMs!

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