What you need to know about investing in a Roth IRA

M1 Team
M1 Team September 24, 2018
What you need to know about investing in a Roth IRA

Individual retirement accounts (or IRAs) are a fantastic way to begin investing and saving for the future because they are tax-sheltered accounts, meaning you’ll pay fewer taxes than other investment account types. But once you’ve decided to invest in an IRA, you’ll still need to choose between the various types.

If you’re self-employed or a business owner looking for a plan for your employees, a SEP or SIMPLE IRA may be a good route for you. But for individual investors, the two most commonly used IRA types are traditional and Roth. To help you get started, we’re taking a look at the Roth IRA and its many benefits to help you decide if it’s the right option for your retirement savings.

What is a Roth IRA and how is it taxed?

A Roth IRA is a type of individual retirement account. Contributions to a Roth IRA are made with after-tax dollars, grow tax free, and do not have taxes when withdrawn in retirement. This is the primary differentiator between Roth IRAs and traditional IRAs, which are funded with pre-tax dollars and grow tax free but require the investor to pay taxes on withdrawals in retirement.

Who can contribute to a Roth IRA?

Roth IRA contributions are limited to individuals making less than a certain dollar amount in annual income. This amount depends on your filing status: for single filers, that’s less than $135,000 per year for tax year 2018. If you are married and filing jointly, the limit is $199,000 (between both spouses). But you’ll want to keep an eye on these numbers from year to year, as these limits can fluctuate.

How much can you contribute?

Like rules around who can invest in a Roth IRA, contribution limits can fluctuate from year to year. For tax year 2018, individuals under the age of 50 can contribute $5,500 annually. Those 50 and over can contribute an additional $1,000 for a total of $6,500 each year (the same limits for traditional IRAs). If you’re looking to max out your contributions, that means investing about $458/month if you’re under 50 and about $541/month if you’re 50+.

Should you contribute to a Roth IRA?

Experts generally recommend investing in a Roth IRA is if you believe you will be in a higher tax bracket when you retire than you are now, but that can be difficult (or downright impossible) to predict years or even decades out.

A few common rules of thumb dictate that you should opt for a Roth IRA if you are younger, have a longer time horizon, and/or already invest in a traditional 401(k). While there’s truth to all of this, the reality is Roth IRAs can be a great choice for investors of any age. Here are a few reasons to considering opening and investing in a Roth IRA:

1. Tax-free retirement income

Investing in a Roth IRA can be a bit like eating healthy: it’s all about avoiding instant gratification in favor of long-term well-being (whether physical or financial). In this moment, eating cake probably sounds better than eating a head of broccoli, just like not paying taxes right now sounds better than, well, paying taxes right now. But just like eating broccoli will have a more positive impact on your health in the grand scheme of things, paying taxes now so you don’t have to pay them in retirement can make a huge difference on your bottom line.

Here’s why: with a Roth IRA, you only pay taxes on contributions — not on earnings. So if you contribute $5,500 to your Roth IRA each year between the ages of 30 and 65, you’ll sock away (and pay taxes on) $192,500 from your own pocket. By 65, your account may be worth, say, $650,000 (given a 6% rate of return annually). That means you don’t pay any taxes on $457,500 worth of earnings! In other words, a Roth IRA allows you to take full advantage of compounding, absolutely tax-free.

2. Fewer age-based restrictions

After age 70 ½ (yes, it’s quite specific), you can no longer contribute to a traditional IRA. With Roth IRAs, you can contribute as long as you live.

Age restrictions can also apply to withdrawals. One of the biggest advantages of the Roth IRA is that there are no required minimum distributions (RMDs) in retirement. Traditional IRAs, on the other hand, require individuals over the age of 70 ½ to begin withdrawing certain amounts from their account each year. Sounds simple enough in theory, but timing is a whole different beast.

For example, if you don’t need the money at age 70 ½, you’ll want to keep it all in the account where it can continue to grow tax-free.  

Or, consider another scenario: you’re 74 and the market plummets. Still, you’re required to take a minimum distribution. That means selling securities to withdraw the amount required, even if that means selling at a loss. With Roth IRAs, on the other hand, you have the option to withdraw more in years the markets are up and less (or none at all) in years the market is down. You’re not required to make a withdrawal at certain times or certain intervals.

Even if markets do provide smooth sailing throughout your retirement years, if you miss a single RMD deadline, the IRS can penalize you with an excise tax of 50% of the amount not withdrawn.

3. Perks for loved ones and future generations

If you want to leave money to your spouse, children, grandchildren, or other beneficiary, a Roth IRA can be a great way to do so. That’s because all money your heirs receive is also tax-free. That means years or even decades more of earning on your investments, and your beneficiaries can reap the rewards at no cost. This is why many individuals use a Roth IRA as an estate planning tool.  

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