Roth IRA: Everything You Need To Know

Thang Truong
Thang Truong
Updated on:

A Roth IRA is an Individual Retirement Account that you fund with after-tax dollars. Because you already paid taxes on this money, it’s tax-free when you withdraw it. That makes it a little different than a traditional IRA, which is also an individual retirement account. However, in a traditional IRA, you invest pre-tax dollars in the account, and the money grows tax-deferred until you withdraw it. 

What is an IRA?

Individual retirement accounts first become available in 1975, to allow Americans to save for their own retirement since fewer and fewer companies offered pensions. Both traditional IRA’s and Roth IRA’s are investment accounts—they hold the money that you invest in things such as mutual funds, stocks, bonds, and exchange-traded funds (EFT’s). You can choose what you invest in, or you can have a robo-advisor do it for you. 

>>MORE: Calculator: How Much Do I Need to Save Monthly for Retirement?

How does a Roth IRA Work?

If you decide to open a Roth IRA, you’ll do the following:

  • Find a brokerage account or a bank. Opening an account is a simple matter of filling out paperwork.
  • Stay within the limits. The contribution limit for 2020 is $6,000 ($7,000 if you’re over 50).
  • You will not get tax break with a Roth, unlike a traditional IRA. A traditional IRA is tax-deductible
  • On the other hand, when you go to withdraw the money, the withdrawals will be tax-free. You’ll need to be at least 59 and ½ to take withdrawals without penalties and have owned the account for at least five years. 

>>MORE: Tax Benefits of Life Insurance: Compare with Other Retirement and Investment Accounts

Is Everyone Eligible to Open a Roth IRA?

Not everyone is eligible to open a Roth. You must have earned income (as opposed to living off of your investments) and you must earn under a certain limit. 

If you are single, your adjusted gross income must be less than $124,000 to fully contribute and less than $139,000 to partially contribute. If you make more than $139,000, you’re out of luck. 

If you’re married, filing jointly you must earn less than $196,000 to fully contribute or $206,000 to qualify for a partial contribution. This is quite a bit higher than the limits for 2019. 

It’s possible to exceed these limits and create a backdoor Roth by opening a traditional IRA and then immediately converting it to a Roth. If you feel your tax rate will be higher when you retire, this strategy might work for you. Learn how backdoor Roth IRA works and how you can set it up step by step at Vanguard.

If you have maxed out your tax-deductible 401K contribution, maxed out your traditional IRA contribution and converted it a Roth IRA account using backdoor approach, and you still want to save more money for retirement, you may want to consider a mega backdoor Roth IRA. The way mega backdoor Roth IRA works is that you contribute after-tax money to your 401K account and have it convert to a Roth IRA account immediately. Learn more about the details of mega backdoor Roth IRA and how to do a mega backdoor Roth IRA with your 401K account at Fidelity.

>>MORE: Retirement Savings Strategies for High-Income Earners

Pros and Cons of a Roth IRA

– Money grows tax-free
– Withdrawals are also tax-free
– No required minimum distributions (RMD)
– The penalty for early withdrawals is only 10%
– In some emergency situations, you can withdraw from a Roth without any penalties
– No age limits on contributions—with a traditional IRA, you must stop contributing at age 70 and ½, but with a Roth you can continue to contribute as long as you like
– You don’t get a tax deduction on what you contribute
– There are income limits
– You can only contribute up to $6000 a year ($7,000 if you’re over 50)
– You have to set it up yourself

>>MORE: How to Start Preparing for Retirement at Age 40?

Robo-Advisors vs. Brokers

You can open a Roth IRA with:

  • Banks
  • Brokerage companies
  • Credit unions
  • Savings and loan associations

Most people open an IRA with a brokerage firm. If you go with a bank, they’ll steer you towards CD’s and Money Market accounts, which are fine but tend to earn less money. Since you’re saving for retirement, you’re going to hold the account for a long time, and therefore you should invest in stocks and bonds. The risk is higher, but the return is greater. Over the long-term, the risk of losing money decreases and most investors will make a higher return than they would on any other type of investment.

If you’re a savvy investor, or just want to try your hand at choosing your own investments, you should choose a brokerage firm. They offer discount brokers, who will let you do all of the work as far as researching what to buy—they just buy and sell what you tell them to. 

A Robo-advisor uses a computer algorithm that builds and manages your investments. They offer a variety of portfolios for you to choose from based on how much risk you’re willing to assume and how much money you have to invest. They usually have lower fees and require lower minimum investments. They’re ideal for beginner investors, because a computer is doing much of the work. 

If you have enough money, you can also go with an online financial advisor. These are more expensive, but they are more hands-on, doing research and making recommendations for you. There’s usually at least a $25,000 minimum, but some require up to $100,000. Fees are higher as well. 

>>MORE: IUL for Retirement Income: Is It a Good Idea?

How to Choose a Brokerage Firm for your Roth IRA Account?

Opening a Roth IRA account is easy and generally just requires filling out some paperwork. Choosing a brokerage in which to open an account is slightly more complicated. Different brokerages have different:

  • Account minimums
  • Trading fees
  • Promotions 
  • Features

Some are really good for doing your own research, some allow you to open a savings or checking account at no extra charge. Some are better for beginning investors and some are better for people who want more hands on management. The point is not every brokerage firm will be a good fit for you, so shop around before making a decision.

>>MORE: Should You Invest in S&P 500 Index Through an Indexed Universal Life Insurance (IUL) Policy?

>>MORE: Understanding Indexed Universal Life Insurance (IUL) – Why Is It a Good Option for Retirement Savings?

Last Thoughts

Although there are some drawbacks to Roth IRA’s, a good retirement strategy will include a Roth IRA. It’s ideal for those who anticipate being in a higher tax bracket later in life, and it also works for retirees who just want access to tax-free cash. Whatever you decide, the earlier you start planning for retirement the better off you’ll be.

Thang Truong

Thang Truong covers small business insurance and small business success at BravoPolicy. He is a licensed P&C insurance agent. Previously, he held product leadership positions at, Capital One, NerdWallet, and Mulberry Technology. He holds a MBA degree from UC Berkeley - Haas School of Business.

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