A Roth Independent Retirement Account (Roth IRA) is a tax-advantaged retirement savings account that allows individuals to save aggressively for retirement while taking advantage of impressive tax savings. Roth IRAs can hold a variety of assets including stocks, bonds, and mutual funds. The money in these accounts grows tax-free, allowing account holders to save a considerable amount of money over time.

How Roth IRAs Work

Roth IRAs are similar to traditional IRAs except in how they are taxed. Traditional IRA deposits are made with pre-tax dollars and Roth IRAs are funded with after-tax dollars. While Roth IRA contributions are not tax deductible, there’s no tax on withdrawals of your contributions.

Much like a traditional IRA, a Roth IRA acts as a savings account for investments. Opened at either a bank or brokerage, the account owner decides what they want to invest in. Popular choices include mutual funds, stocks, bonds, exchange-traded funds (ETFs), and bank savings products. The account holder may invest one lump sum or make smaller contributions throughout the year.

Annual contributions made to a Roth IRA cannot exceed $6,000 or an individual’s taxable contribution, whichever amount is smaller. This number jumps to $7,000 for account holders over 50 years of age.

Roth IRA Benefits

Roth IRAs offer numerous benefits. For example, a Roth IRA allows the account holder to withdraw money without taxes or penalty. This is different than a traditional IRA or 401(k) contribution plan.

Another benefit, individuals can make contributions to both a Roth IRA and a 401(k) at the same time. This makes it possible to increase the amount of money saved. The investment growth in both a Roth IRA and a 401(k) is tax-deferred until retirement.

Those wishing to open a Roth IRA can choose when and how much money they contribute. While some people choose to contribute the maximum amount of $6,000 ($7,000 for taxpayers over 50) in one lump sum, many others prefer to spread this amount throughout the year. As long as taxpayers stay within the annual maximum, they can make as many contributions as they wish within a one-year period. Participants have until the tax deadline of April 15th to contribute to the previous year.

At 59 ½ years of age, investors can take distributions, including earnings, from their Roth IRA without paying federal taxes, provided they have held the account for at least five years. Because the contributions can be withdrawn at any time without taxes or penalties, this type of savings account is ideal for individuals with goals such as buying a house or paying for a child’s college education.

Anyone can open a Roth IRA as long as they have earned income. Earned income can come from a variety of sources and includes all income earned from working for someone else, or self-employment. Additional forms of earned income include untaxed combat pay, military differential pay, taxed alimony, and disability benefits.

Who Benefits Most From Using a Roth IRA?

Roth IRAs are an excellent choice for anyone that believes their tax rate might go up in the future. Since taxpayers pay income tax on Roth IRA contributions, it only make sense to make these contributions while their tax rate is low. However, opening a Roth IRA makes sense even for people who aren’t sure what their future tax bill will look like.

Downsides of Roth IRA

Like any other tax-advantaged retirement plan, the IRS has specific rules regarding contribution limits, income limits, and how account owners can withdraw their money. $6,000 is the maximum annual contribution allowed for 2019 and 2020. However, account holders over 50 can contribute up to $7,000.

It’s important to note that annual contributions cannot exceed earned income and couples cannot obtain a joint Roth IRA. This can make obtaining an account difficult if one spouse earns more than the other. However, couples can still accomplish their goals of contributing large sums to retirement if each spouse opens their own Roth IRA.

Perhaps the biggest downside, people that make too much money are not eligible to open a Roth IRA. IRS income limits for Roth IRA eligibility are based on modified adjusted gross income (MAGI). Individuals must make less than $124,000 to contribute the maximum amount and less than $139,000 to contribute a reduced amount. Individuals that earn over $139,000 or $206,000 for married couples cannot contribute to a Roth IRA.

Another drawback, account holders cannot contribute unearned income to a Roth IRA. Unearned income includes any type of investment income earned from securities, rental property, or other assets.

Paying Taxes on Roth IRA

Unlike traditional IRAs which have an up-front tax deduction, account holders make contributions to a Roth IRA with income that’s already been taxed. Roth IRA account holders cannot get a tax deduction on the earnings they contribute. For example, if an individual contributes $5,000 each year to a Roth IRA, they pay taxes on that money each year before making their deposit.

Since all tax is paid up front on all contributions to a Roth IRA, all returns the investment earned over the life of the account are tax-free. Once the account holder meets the 59 ½ age limit and 5-year holding period requirements, they can begin making withdrawals from their Roth IRA without any tax liability. Instead of getting the tax break up front, Roth IRA account holders get it on the back end of the investment.

At Dechtman Wealth Management, we’re dedicated to helping our clients meet their financial goals. Please contact us for more information about Roth IRAs.