What is a Roth IRA?

When you started researching retirement options, you probably came across Roth IRAs pretty quickly. On paper, they sound pretty appealing: you fund them with money you’ve already paid taxes on. But unlike a normal brokerage account, your investments then grow tax-free, and, unlike traditional IRAs, you don’t pay any taxes on withdrawals you make in retirement with a Roth IRA. And you can take out your contributions anytime without penalty. Sounds great, right?

There are a lot of benefits to opening a Roth IRA. But they aren’t quite as simple as that, and they aren’t available to everyone. Here’s everything you need to know about funding your post-work life by opening a Roth IRA.

What is a Roth IRA?

Named after the senator who championed the plan, a Roth IRA is a type of Individual Retirement Account (IRA) that helps you save for retirement with certain tax benefits. Those tax advantages are one of the key things that differentiates retirement accounts from regular investment accounts and makes them such a powerful tool for building wealth.

Traditional vs. Roth IRA

Unlike with a traditional IRA, your money isn’t tax-deductible today. But you won’t pay taxes on it as it grows, and you can withdraw all of it tax-free once you’ve reached retirement age, which our friends in the federal government currently define as 59½. Traditional IRAs, on the other hand, may allow tax-deductible contributions now, but you’ll be taxed on any withdrawals you make in retirement.

Understanding Roth IRAs

To Roth or not to Roth is a topic of much debate among financial advisors that fundamentally comes down to one question: Do you think you’re going to earn more money (and therefore be taxed more) now or later? If the answer is now, you might benefit from a traditional IRA that may allow you to deduct your contributions to lower your taxable income level.

If you think you may make more money in retirement (and therefore will probably be in a higher tax bracket), you may want a Roth IRA. You won’t be able to decrease your tax burden now, but because you’re already square with Uncle Sam tax-wise, you won’t have to settle up later.

Some financial advisors are particularly fond of Roth IRAs because of the certainty surrounding them when it comes to paying taxes. It’s impossible to predict what tax brackets will look like in the future, and a Roth IRA assures you that you won’t owe part of your nest egg to the federal government in retirement.

If you’re unsure, experts also recommend having some diversity in your tax-advantaged retirement accounts. That means if you have a traditional 401(k) through your work, you might opt for a Roth IRA so you have more tax options when you’re ready to retire.

Funding a Roth IRA

Contribution Limits 

You can contribute up to $6,000 for 2020 ($7,000 if you’re 50 or older). But there are income restrictions.

Income Limits

To max out the account in 2020, you must earn less than $124,000 individually, or $196,000 if you're married and filing jointly. 

You may still be able to make a reduced contribution if you make more than $124,000 but less than $139,000 individually or more than $196,000 but less than $206,000 if filing jointly. Check with your financial advisor to determine what your reduced contribution may be if you fall in those income tax brackets.

Other Contribution Restrictions

You must have earned an income in a given year to contribute to a Roth IRA. In addition, regardless of current contribution limits, you cannot invest more than your earned income a year. That means if you only made $1,000 in 2019, you can’t contribute more than $1,000 to your Roth IRA.

Withdrawing from a Roth IRA

Early Withdrawals

A major perk of Roth IRAs is that you can withdraw your contributions anytime without penalty. However, if you dip into your investment earnings before 59½, you may owe a 10 percent penalty and taxes.

That means if you’d put in $5,000 and your account value had risen to $5,500, you could take out $5,000 without penalty, but anything more would be subject to the penalty and taxes.

A potential exception is if you have had your Roth IRA for at least five years and you’re making the withdrawal because you are disabled or if you are using it to rebuild or buy a first home.

But remember: anything you take out of your Roth IRA before retirement is money that isn’t able to compound in your investment account. So even if you withdraw a seemingly small amount early on, keep in mind that money could have grown greatly over time through compounding.

Required Minimum Distributions

Unlike a traditional IRA, Roth IRAs have no required minimum distributions, meaning you don’t have to start making withdrawals when you turn a certain age. That’s a major advantage of Roth IRAs, as they allow your money to continue to grow tax-free for longer.

Opening a Roth IRA

Most brokerages offer traditional and Roth IRA options with a range of investment options. The Acorns Later IRA determines the right IRA type for you and then provides a personalized portfolio of low-cost, diversified exchange-traded funds (ETFs) based on your target retirement age. Through Acorns Later, you can start investing for your retirement with contributions of as little as $5. (Click here to set up a Later account in just a few minutes.)