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What is a Roth IRA?

What is a Roth IRA?

The Roth IRA is a self retirement account in which money grows tax-free, and withdrawals during retirement are tax-free.

Individuals who are at least fifty-nine and a half years old and keep their accounts for at least five years can receive distributions, including income, without paying federal tax.

 

Understanding How a Roth IRA Works

Here is a summary to help you understand the basics of a Roth IRA.

  • Invest the money in the account: A Roth IRA is an individual retirement account that holds your investments, rather than an investment in itself. You can lose money or earn money with a Roth IRA. What you earn and if you lose money depends on how you invest.

  • Open a Roth IRA account with a Broker or Bank: Then select what you want to invest in, such as stocks, mutual funds, bonds, exchange-traded funds (ETFs), or bank savings products. For a long-term goal, such as retirement, we recommend investing in stocks and bonds because of their higher returns. This means opening your Roth with a broker or Robo-advisor, not a bank. 

  • You can add money over time: You can make a lump sum or make smaller contributions throughout the year, as long as your contributions do not exceed $ 6,000 ($ 7,000 if you are 50 or older) or your taxable payment, depending on the highest amount. This is the maximum annual contribution in 2020. You can also add money to a Roth by transferring money from another retirement account.

  • Your contributions are not tax-deductible: Unlike traditional IRAs, you do not receive a tax deduction for your contribution to a Roth IRA.

However, withdrawals are exempt from taxes. In general, you can withdraw your contributions without paying fines or taxes (you have already paid taxes on the money you invested).


Who is eligible for a Roth IRA?

Here are the ground rules and qualifications.

• You must have earned an income: To contribute to a Traditional or Roth IRA, you must have earned an income (the IRS term is "taxable compensation"). The maximum annual contribution is earned income or $ 6,000 ($ 7,000 if you are over 50), whichever is less.

• Must be below the Income Limit: The amount that you can contribute to a Roth IRA begins to decline within certain modified adjusted gross income limits and continues to decline as your income increases until your ability to contribute is eliminated. 

Note: Income limits apply to Modified Gross Income (MAGI), Adjusted Gross Income, with some deductions and exclusions added. 

How to open a Roth IRA Account

Most online brokers, banks, and Robo-advisers offer Roth IRAs.

  • Banks: Since most banks offer access to savings (like CDs) rather than investing, they are usually not the best place to open an IRA, which should be geared towards long-term growth.

  • Robo-Advisor: A good first step in the Roth IRA buying process is deciding if you want a direct investment approach, in which case a Robo-and automated investment process may be appealing or a more active investment choice approach, which could make a traditional broker more attractive.


Roth IRA Withdrawal Rules

Here are things to keep in mind.

  • You can withdraw your initial contributions at any time, without paying fines or fees, no matter how long you have opened your account because the money you invest is money you have already paid income tax on.

  • When withdrawing money from a Roth IRA, the IRS always assumes that your initial contributions come out first.

  • Eligible withdrawals of investment income from the account are tax exempt. However, under certain circumstances, the IRS may require some of these returns, in the form of taxes and a possible penalty, if you make an advance withdrawal or violate the rules for a qualifying withdrawal.

 

The Benefits of a Roth IRA Account

  • Roth IRAs are worth it if you anticipate your tax rate to be higher in the future. It's because you are paying money now that you will be paying income tax this year. In other words, you are not exempt from tax on your contributions; with a Roth, the tax exemption comes later. If your tax rate is more economical now, it makes sense to pay your taxes now in exchange for non-taxable retirement taxes. But even if you're unsure of your future tax bill, opening a Roth IRA can be a smart move for other reasons. 

  • Double Dipping: You can contribute a Roth in addition to a 401 (k). This year, the Roth limit is $6,000 annually ($ 7,000 if you're over 50), $ 5,500 to $ 6,500 in 2018.

  • Easy withdrawals: You can easily withdraw the money you contributed at any time without taxes or fines. (You may have to pay taxes or fines if you withdraw your investment income.)

  • Enough time to contribute: You have until the deadline to contribute from the previous calendar year.

  • Flexible Timing: You can choose when to contribute to a Roth IRA and how much to contribute up to the annual maximum. For example, you can contribute $ 6,000 on the first day of the year or spread your contributions over several months.

  • No RMD: Roth IRAs have not been subject to the required minimum distributions by a traditional or 401 (k) IRA for 72 years (in 2019 and prior years, that age was 70 and a half).

  • Tax-free distributions: Once you reach 59½ and have held your account for at least five years, you can receive distributions, including income, from a Roth IRA without paying federal taxes.

  • There is no Age Limit to Creating an Account: You can open a Roth IRA at any age, as long as you earn income (you cannot contribute more than your income).


Roth IRA versus. Traditional IRA

The bottom line is that if you want an immediate tax cut, consider a traditional IRA. If you like the idea of tax-free retirement income, a Roth IRA is a good idea.

• Roth IRAs is an intelligent savings tool for young people just starting as they are likely to face higher tax rates as they progress in their careers. 

• A person more advanced in their career may also want a Roth IRA because it provides tax-free income in retirement. It offers what some financial advisers call "tax diversification."

• Money hidden in accounts, such as 401 (k) s and traditional IRAs, generates tax accounts during retirement. A Roth IRA can provide a convenient way to manage that tax bill, for example, extracting at least some of Roth's income to avoid being pushed into a higher tax category.


Bottom Line

Although not tax-deductible, contributions to a Roth IRA offer the option of creating a tax-free savings account. You can use the Roth IRA in retirement or leave it as an inheritance for your heirs. Roth IRAs offer many of the benefits of regular IRAs, but with more flexibility. They work well for people who might need tax cuts later than before. Opening one is easy, and there are many great Roth IRA providers out there that manage these accounts.


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