Updated for 2021
A Comprehensive Guide to Roth IRAs
Since being first introduced in 1997, Roth IRAs have become an increasingly popular retirement savings vehicle, and understandably so. There’s a lot to like about Roth IRAs, particularly for younger investors who can benefit the most from many of these accounts' features. While most people have at least heard of a Roth IRA, there tends to be a lot of confusion regarding the details and nuances of these accounts. This article is meant to clarify what exactly a Roth IRA is, what it isn’t, and why I think it’s a great place for investors, particularly younger professionals, to start saving money for retirement.
What is a Roth IRA?
A Roth IRA is a type of Individual Retirement Account that allows investors to contribute up to $6,000 ($7,000 for anyone age 50 or older) each year in post-tax dollars. Contributions grow on a tax-deferred basis and, if held until age 59 ½, the investment earnings can be withdrawn tax-free!
Can Anyone contribute to a Roth IRA?
There are two main stipulations that you must meet in order to directly contribute to a Roth IRA:
1.) You must have earned income for the year in which you make the contribution. Stay-at-home parents are excluded from this requirement as long as they have a spouse that has earned income for the year.
2.) Your Modified Adjusted Gross Income (MAGI) for the year must not exceed the maximum allowed by the government for that year. (see "Limitations of Roth IRA" section below for more information).
Main Benefits of a Roth IRA
Tax-free growth
While there are several great features of the Roth IRA that we will cover in this article, the main reason that most people open up a Roth account is to take advantage of the tax-free growth that these accounts provide. No one likes to pay taxes, so this is a big draw for individuals of all ages, but this tax-free growth is especially beneficial for younger professionals that are still in the early to mid-portions of their career for three main reasons:
1.) Generally, you will make more money near the end of your career than the beginning or middle portions of your career. Thus, the ability to pay taxes on the money on the front-end, while you’re in a lower tax bracket, and enjoy tax-free withdrawals on the back-end, when you’re in a higher tax bracket, is a great deal long-term.
2.) If you’re in your 20s, 30s, or 40s, your Roth IRA has decades to grow and compound before you need it during retirement. When it comes to investing, time and compounding interest are your friends and can turn your Roth account (assuming you've contributed consistently to it over the years) into a substantially larger account that that you can access tax-free by the time you're ready to retire.
For example, let's say that a married couple (both 30) decides that they are both going to start maxing out their Roth IRAs each year ($6,000 each, $12,000 in annual contributions total) between now and when they want to retire at age 65. Assuming that they averaged an 8% rate of return over that period of time, by the time that they were ready to retire, their total contributions would have been $420,000, but their account would have grown to $2,067,802, all of which could be withdrawn tax-free!
3.) Most retirement accounts (401(k)s, 403(b)s, Traditional IRAs, SEPs, Simple IRAs, etc.) are in pre-tax dollars and will be taxed at ordinary income tax rates when withdrawn during retirement. Having a tax-free bucket of savings to compliment the other assets that you have in pre-tax accounts gives you more flexibility and prevents you from having to withdraw too much income from pre-tax accounts that could result with you being in a higher tax bracket.
Contributions can be withdrawn from the account at any time
While Roth IRAs are intended to be a long-term savings vehicle for retirement (and I would encourage you to think of them as such), your contributions to a Roth IRA, unlike 401(k) and traditional IRA contributions, can be withdrawn at any time for any reason without paying taxes or penalties. * This allows more flexibility and liquidity for the owner of the Roth IRA over other retirement accounts.
*Note that this applies to solely your contributions, as the investment earnings in Roth IRA accounts cannot be withdrawn until age 59 ½ (see below), and some Roth conversions must adhere to the five-year rule (see below).
Early Withdrawal for First-Time Homeowners
The IRS allows first-time homeowners to withdraw up to $10,000 of investment earnings (in addition to withdrawal of all contributions) from their Roth IRA accounts without paying taxes or penalties on that money, provided the account has been open for at least 5 years. In this instance, “first-time homeowners” is defined as anyone who has not owned their principal residence over the last two years. If you are married, both you and your spouse must meet the definition of a first-time homeowner to utilize this exception, but each are allowed to withdraw up to $10,000 in earnings from their respective Roth accounts. This is a lifetime $10,000 exception per person, so it’s most likely a one-time transaction for most individuals.
No RMDs
Most tax-deferred retirement accounts (401(k)s, Traditional IRAs, 403(b)s, etc.) require the owner to start making age-based minimum withdrawals from their accounts each year beginning at age 70 ½, whether the money is needed or not. As the individual gets older, the portion of the account that must be withdrawn each year gets larger and larger. These Required Minimum Distributions (RMDs) are an annual source of frustration for retirees. Not only do they have to withdraw money that they don’t need from accounts that were growing tax-deferred, but they also have to pay ordinary income tax on all the money withdrawn.
Roth IRAs have none of these RMD requirements. Owners can let their account assets continue to grow tax-free until they actually NEED the money for income in retirement.
Pay for Higher Education Costs
Unbeknownst to most people, you may use Roth IRA investment earnings to fund higher education expenses for yourself or certain family members (your spouse, children and grandchildren of you or your spouse). This exclusion only applies for education expenses that were incurred in the same year as the distributions from the Roth IRA, and do not include any expenses paid with a Pell grant, tax-free distributions from a Coverdell account, or the tax-free part of a scholarship or fellowship. Additionally, the Roth IRA must have been open for at least five years.
Limitations of the Roth IRA
While there’s a lot to like about Roth IRAs, there are a few limitations of these accounts that you should be aware of before opening up an account.
Annual Contribution Limits
Each individual is allowed to annually contribute up to $6,000 ($7,000 for anyone 50 or older) cumulatively spread across all Roth IRAs and traditional IRAs that the individual owns. For example, someone under 50 who contributes $3,000 into a Roth IRA and $3,000 into a Traditional IRA would be acceptable transactions, as the combined contributions for the year would not be more than $6,000. However, contributing $6,000 into both accounts would put the individual over the $6,000 threshold for the year and would not be acceptable in the eyes of the IRS. Note that each individual is allowed to contribute up to $6,000, so a married couple would be allowed to contribute up to $12,000 in their IRA accounts in a given year.
Income Limits
Unfortunately, not everyone can contribute directly to a Roth IRA, as there is income limitations based on the individual’s (or couple’s) Modified Adjusted Gross Income (MAGI) for the year. For tax year 2021, a married couple, filing jointly, starts seeing Roth contributions begin to phase out once their MAGI is above $198,000 and any couple who has a MAGI of $208,000+ is not allowed to make a direct contribution to a Roth at all for that year. Similar income limits apply to singles as well; phase out of Roth contributions begin at MAGI of $125,000 and anyone with MAGI of $140,000+ is ineligible to make direct contributions to a Roth.
If your MAGI is too high to directly contribute to a Roth IRA, don’t worry! A backdoor Roth IRA conversion might be a good alternative for you that, with a couple of extra steps, will still let you contribute to a Roth IRA like everyone else.
Must be at least 59 ½ to Withdraw Investment Earnings without Taxes and Penalties
The government intends Roth IRAs to be used for retirement purposes, thus it requires that you be at least age 59 ½ before you withdraw investment earnings from the account. Should an individual withdraw funds early, they will be taxed at ordinary income tax rates and will be assessed an additional 10% early withdrawal penalty.
As previously mentioned above, there are some exceptions to these early withdrawal penalties. The following distributions would not be assessed the early withdrawal penalties:
You become totally and permanently disabled
You are the beneficiary of a Roth account whose owner is deceased
You are a first-time homeowner who uses a distribution of up to $10,000 to pay for the purchase of the home
The distributions are part of a series of substantially equal payments
Distributions for unreimbursed medical expenses that are more than 7.5% of your adjusted gross income
Using the distributions to pay for medical insurance premiums while unemployed
Use the money to pay for higher education costs for yourself or a qualified family member (your spouse, children and grandchildren of you or your spouse)
Distribution due to IRS levy to pay owed federal back taxes (only applicable for IRS levies on back-taxes, you cannot pull out money to pay your federal taxes that you currently owe)
Qualified Reservist Distributions
Qualified Distribution for Disaster-Related Relief (such as hurricanes)
Some of the exceptions listed above are beyond the scope of this article. For more detailed information on each of these exceptions, check out this IRS publication.
Five-Year Rule
While contributions can be withdrawn at any time, investment earnings and taxable Roth conversions each have variations of a five-year rule that require funds to stay in the account for a minimum of five calendar years before being able to withdraw funds without penalty. This applies to all owners, regardless of age.
Five Year Rule for Investment Earnings - The five-year period starts at the beginning of the tax year when the owner first contributed to the Roth IRA account. For example, let’s say that Jimmy (age 60) opened up a Roth IRA account and made his first contribution in May of 2010. His five-year window for ALL investment earnings in that account begins on January 1st of 2010. On January 2nd, 2015, having now satisfied the five-year rule as well as the age requirement, he will be able to remove all investment earnings from his Roth account without incurring penalties. If money is withdrawn within five years, a 10% early withdrawal penalty will be assessed. This is in addition to the ordinary income tax that will be due for those who are under 59 ½ .
Five Year Rule for Taxable Roth Conversions - Each conversion has its own five-year period that begins January 1st of the year in which the conversion was performed. For example, in August 2014 Jimmy converted his old IRA over to a Roth IRA, then two years later in March 2016 he converted an old 401(k) to his Roth account. The money that came over from the IRA will have a five-year period that begins January 1, 2014 and the money that came over from the 401(k) will have a five-year period that begins January 1st, 2016. Money withdrawn before the end of the five-year period will be forced to pay a 10% early withdrawal penalty, but since taxes have already been paid at the time of conversion the withdrawal will not require the owner to pay income taxes. After the five-year rule has been satisfied, funds are pretty much treated like any other contribution and can be withdrawn at any time for any reason.
What Investments Can Be Held within a Roth IRA?
Almost any investment can be held within a Roth IRA, except for two main exclusions: life insurance contracts and collectibles. While you CAN invest in a wide range of exotic investments, that doesn’t mean you should. I’d encourage most people to invest in low-cost, diversified mutual funds and ETFs.
Can I Contribute to Both My Roth IRA and My 401(k) through Work?
Absolutely! The IRS allows you to contribute to both a 401(k) and a Roth IRA in the same year. Most people, particularly those whose employer offers a 401(k) match, end up contributing to both.
Should I contribute to my 401(k) or Roth IRA first?
I’ve written before about how good of a deal the employer match is. If your employer offers a matching 401(k), max out the portion that your employer offers to match before looking to start a Roth IRA. For example, if you make $100,000 a year and your employer offers a dollar for dollar match up to 3% of your income (meaning if you put in 3% of your income in the 401(k) then they will put in an additional 3% match), then the first $3,000 that you commit toward retirement savings each year should go towards your 401(k) before you look to open a Roth IRA. Once the employer match has been maxed out, only then look to invest in a Roth IRA.
Should I Invest in a Roth IRA or a Traditional IRA?
Both the Roth and the Traditional IRA offer tax-deferred growth, so while there are some other small differences between accounts that might lean in the Roth’s favor, I think it truly boils down will the tax-deduction now (traditional IRA) or the tax-free future withdrawals (Roth IRA) be best for you long-term? If you’re in the middle of your peak earning years and are planning on retiring in the next 5-10 years, then it might be more beneficial to go with the Traditional IRA and take the tax deduction now, as you have limited years for the Roth to compound on your behalf. Alternatively, if you are in the early to mid-years of your career, you most likely will benefit more from contributing to a Roth IRA, as you will most likely be making more money later in your career than you right now, and could very well be in a higher tax bracket. Additionally, you have more time to allow the Roth to accrue and compound, leaving you with a large pot of tax-free money somewhere down the road.
Conclusion
Tax-free growth and the ability to withdraw contributions without penalty sets the Roth IRA apart from most other retirement accounts, making it a great potential option for most younger investors. If you want to have a more detailed discussion on whether a Roth IRA is the right fit for your particular situation, feel free to email me at daniel@sweetgrassfp.com or schedule a free introductory consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
