What Is a Roth IRA Retirement Account? | Explaining the Basics

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The Roth IRA is a fantastic investment vehicle. It allows you to build a wonderful next egg for retirement and build tax advantaged wealth. Let’s get into the amazing benefits. 

What Is a Roth IRA? 

The Roth IRA, short for Individual Retirement Account, is one of the most promising and easy-to-follow retirement-savings plans available out there. 

It is a tax-advantaged savings account, which means that not only do your contributions grow tax-free but you are also exempted from tax payments when you withdraw your money in the future. 

You can open a Roth IRA account at a brokerage or a bank and then choose your preferred mode of investment – i.e., stocks, bonds, mutual funds, bank savings products, exchange-traded funds (EFTs), and so on.

The Roth IRA plan was first introduced in 1997 and it is named after a former Delaware Senator, Willian Roth. 

Roth IRAs vs. Traditional IRAs

Roth IRAs are similar to the traditional IRA plans in many aspects. But the main difference that sets one apart from the other is the way these accounts are taxed. 

Simple IRAs are funded with pretax dollars. That is, your contributions are tax-deductible but when you withdraw the money (be it during or before retirement), you will have to pay an income tax on it as usual. 

On the other hand, Roth IRAs follow the exact opposite rules for taxation. These savings accounts are funded with after-tax dollars. So, you do not get any tax-deductions on your contributions, but you can withdraw your savings completely tax-free whenever you want.  

Who Should Open a Roth IRA?

A Roth IRA is the ideal saving option for those inclined towards a ‘pay now, save later’ approach for getting a tax advantage. It is one of the most sought-after retirement-savings plans among employees who are not eligible for the famous 401k plans. 

However, many employees, despite being eligible for a 401k plan, opt for a Roth IRA instead. This usually happens if they think they will be able to save more this way as compared to their employer-sponsored matching contributions plan.

Moreover, Roth IRA is an attractive option for those who are likely to be in a higher tax bracket down the lane. If you are earning well and thus, expect your tax rate to be higher in the future, investing in Roth IRA can be a smart move. This is because you will pay income tax now and enjoy a tax break on your retirement withdrawals. 

Since there are no restrictions on withdrawing funds from a Roth IRA, they are a good savings tool not only for your golden years, but also for meeting other financial goals like saving for college or buying your own house. 

What Are the Roth IRA Rules? 

Some of the main pointers about Roth IRAs that potential account holders ought to know are as follows:

  • There is no age limit. Contributions to this retirement savings account can be made at any age and for as many years as you want given that you have earned income that qualifies. This is a huge advantage over traditional IRAs where you cannot contribute after age 70 ½.
  • Unlike traditional IRA and 401k plans, Roth IRA does not have a Required Minimum Distribution (RMD). So, your savings can continue growing even after you have retired
  • Your Roth account can be funded in several different ways including personal/ regular contributions, rollover contributions, transfers, conversions, and IRA contributions from your spouse, to name a few.
  • Regular contributions to Roth IRA can only be in cash or check. In other words, you cannot deposit money in this account in the form of assets or securities. 
  • You can deposit the money as a lumpsum amount or make multiple contributions throughout the year. The annual contribution, however, must not exceed the maximum contribution limit (discussed later).
  • There are no income taxes for inherited Roth IRAs. So, if you pass on your account to your heirs or conversely, have inherited a Roth IRA from a family member, all withdrawals will be tax-free

What Are the Roth IRA Maximum Contribution Limits? 

Just like almost all other types of saving plans, the IRS limits the amount of money you can hold in a Roth IRA. The limits are increased periodically to compensate the rising cost of living. 

For the tax year 2019 and 2020, the maximum contribution limits for a Roth IRA are as follows:

  • For individuals under 50 years of age: $6,000
  • For those aged 50 and above: $7,000

Keep in mind though that you cannot contribute more than you have earned during a given year. So, if your annual income is less than these figures due to any reason, the maximum contribution limit for your Roth IRA account during the same time period will depend on what you earned instead. 

What Are the Roth IRA Withdrawal Penalties? 

Generally speaking, you can withdraw funds from your Roth IRA account any time you want without facing a penalty or paying any other similar charges. 

However, to withdraw earnings or investment returns without penalty, you must fulfil certain criteria. Here is a brief overview of Roth IRA withdrawal rules:

For people aged 59 ½ or older:

If you have owned the account for at least five years, you can withdraw earnings without any tax or penalty. Otherwise, you will have to pay income tax on the investment returns that you withdraw (but no penalty).

For people younger than 59 ½:

If you have owned the account for at least five years, you can withdraw earnings without penalty if you meet one of the following conditions:

  • You are withdrawing a max of $10,000 to buy your first house
  • You need financial help due to your disability
  • The withdrawal is made to your estate or any other beneficiary after your death

If you haven’t owned the account for five years at the time of withdrawing your earnings, you will be liable to pay income taxes along with a 10% early withdrawal penalty. However, the penalty can be waived off if the withdrawal is for any of the following reasons:

  • Buying your first house (for amounts up to $10,000)
  • Qualified education expenses
  • Personal expenses in the year after you welcomed or adopted a child (for amounts up to $5,000 max)
  • Health insurance payments while you are unemployed
  • Financial help due to a disability
  • Payment to your estate or beneficiary after your death
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