A Roth individual retirement account (IRA) is an individual retirement account that allows investors to contribute up to $6,000 per year for retirement. Unlike traditional IRAs, Roth IRAs allow post-tax contributions that then grow tax-free and are withdrawn tax-free during retirement. Roth IRAs are ideal for tax-conscious investors who want to lessen their income tax burden during retirement.
How a Roth IRA Works
A Roth IRA is similar to other IRAs because it allows investments to grow tax-free. However, Roth IRAs give investors a tax benefit during retirement while traditional IRAs and other tax-deferred accounts give investors a tax break up front. To use a Roth IRA, however, investors still have to follow Roth IRA rules.
Although 2019 Roth IRA contribution limits are the same as traditional IRAs, there are differences that need to be taken into consideration. First, Roth IRA contributions are after-tax while traditional IRA contributions are pretax. This means that, in pretax dollars, Roth IRA contributions cost more than traditional IRA contributions.
The biggest drawback to Roth IRAs is that not everyone can have one. In order to contribute, you need to meet certain Roth IRA income limits and other eligibility requirements. Roth IRA contributions limits are also offset against traditional IRA contribution limits, so if you already contribute $6,000 to a traditional IRA, you won’t be able to contribute to a Roth IRA.
Roth IRA Costs
The costs of a Roth IRA are very minimal, just like those of a traditional IRA. Roth IRA costs vary by provider but are mostly related to specific investments or the costs of trading. Most financial institutions also charge a small annual fee for holding IRA assets on behalf of clients.
Typical Roth IRA costs include:
- Custodian fee: $20-$50 per year — IRA assets must be held by IRA custodians approved by the IRS, which typically charge a small annual fee
- Fund expense ratio: 0.05%-1.5% per year — Every mutual fund and ETF charges an expense ratio that covers costs of trading and management for the fund
- Trading commissions: $5-$50 per trade — You’ll pay a fee for each transaction whenever you trade stocks, bonds or other securities in your Roth IRA
Roth IRA Contribution Limits & Deadlines
2019 Roth IRA contribution limits are $6,000 and must be made before April 15, 2020. Contribution limits can change from year to year and are offset against traditional IRA contributions. While Roth IRA contributions are after-tax, all withdrawals from a Roth after you reach age 59 1/2 are after-tax while traditional IRA withdrawals are taxable income.
Roth IRA Contribution Limits & Deadlines
Limits (without catch-ups)
(if you’re over 50)
While the 2019 Roth IRA contribution limit is $6,000, these contribution limits can vary based on Roth IRA income limits and eligibility for employer-sponsored retirement plans. It’s also worth noting that, unlike other IRAs, Roth IRA contributions are after-tax, so they’re actually more expensive. Every dollar of Roth IRA contributions equals $1.11 to $1.39 in pretax earnings.
In addition to direct Roth IRA contributions up to $6,000 — $7,000 if you’re age 50 and older — there are other ways that you can contribute to a Roth IRA. One way is to roll funds over from a Roth 401(k) account if you’ve recently left an employer that offered this benefit. Another way is by doing a Roth IRA conversion that allows you to convert a traditional IRA or another tax-deferred account into a Roth IRA.
Roth IRA Deadlines
There are very few deadlines for Roth IRAs. These IRAs do not cover employees or require much administration, so the two primary deadlines are for account setup and contributions. In both cases, Roth IRA deadlines are based on the account holders tax-filing deadline.
The two primary Roth IRA deadlines are:
- Account formation deadline (tax-filing deadline for effective year): When you decide to set up a Roth IRA that’s effective for a given year, you must establish the account prior to your tax-filing deadline for that year; this means that if you want to set up a Roth that’s effective for 2019, then you need to do so prior to April 15, 2019
- Annual contribution deadline (tax-filing deadline for that year): Any Roth IRA contributions need to be made prior to your tax-filing deadline for the year you’re making the contributions effective; in other words, if you want to contribute for 2019 you need to do so before April 15, 2019
Roth IRA Income Limits
Not everyone is eligible for a Roth IRA. In addition to age limits — those age 70 1/2 or older can’t contribute — your income needs to fall below certain limits if you want to contribute to a Roth IRA. These limits vary by filing status and modified adjusted gross income (MAGI), with phase-outs generally starting at $120,000 to $189,000.
|Married Filing Jointly|
|Qualifying Widows and Widowers|
|Married Filing Separately (lived with spouse in past year)|
|Single, Head of Household or Married Filing Separately (haven’t lived with spouse in past year)|
If you exceed Roth IRA income limits, you may not be eligible to contribute to a Roth IRA. One option that you might consider is checking with your employer to see whether they offer a Roth 401(k) through your retirement benefits. If you’re self-employed, you might consider setting up your own 401(k) that includes a Roth feature.
Alternatively, you could always set up a typical brokerage account that you can contribute to. Your contributions will be after-tax, and you’ll need to pay taxes on interest income or capital gains from year to year, but you’ll also be able to access your account at any time, rather than having to pay early withdrawal penalties if you take distributions before age 59 1/2.
Roth IRA Rules
Setting up and administering a Roth is simple. Once you know that you’re eligible for a Roth IRA, there aren’t many Roth IRA rules that you need to follow. In addition to following the Roth IRA deadlines and income requirements, it’s important not to claim tax deductions for any Roth IRA contributions and to avoid taking early withdrawals.
The four main Roth IRA rules include:
1. Meet Roth IRA Eligibility Requirements
You need to have earned income for the year if you want to make Roth IRA contributions. If your taxable income is $0 or negative, then you aren’t allowed to contribute. You also can’t contribute more than you earned for a year. To qualify, you also need to meet Roth IRA income limits outlined above.
2. Roth IRA Early Withdrawals Prohibited
The minimum age for withdraws under Roth IRA rules is 59 1/2 — the same as many other qualified retirement plans. Once you make contributions to a Roth IRA, all contributions and gains must stay in the account until you reach age 59 1/2. Taking early withdrawals before age 59 1/2 can lead to penalties and other taxes.
3. Required Minimum Distributions for Roth IRA Beneficiaries
Unlike traditional IRAs, Roth IRAs do not have required minimum distributions for account holders starting at age 70 1/2. However, if someone other than your spouse inherits your Roth IRA account, he or she will have required minimum distributions to meet.
According to IRS rules, he or she can either withdraw the entire account by the end of the calendar year five years after you die or can take withdrawals using a formula based on his or her life expectancy. However, but these have to start by the end of the year following the year of your death.
4. 5-year Hold Before Making Withdrawals
If you open a Roth IRA or Roth 401(k), you must hold the account for at least five years before making any qualified withdrawals. This means that if you open a Roth IRA at age 58, even though you would theoretically be eligible for tax-free Roth IRA withdrawals starting at age 59 1/2, you must wait until at least age 63 before taking any distributions from your Roth IRA.
Roth IRA Investment Options
Investment options available within a Roth IRA vary by provider but typically include stocks, bonds, mutual funds and exchange-traded funds (ETFs). Those investors who want to focus on passive Roth IRA investment options are better off with mutual funds and ETFs, although more active investors can also trade stocks and bonds in a Roth IRA.
Some traditional IRA investment options typically available include:
- Stocks: Shares in companies that trade on exchanges
- Bonds: Debts issued by companies and public entities
- Mutual funds: Baskets of stocks and bonds that are professionally managed
- Target date funds: Mutual funds that shift from stocks to bonds over time as a certain date approaches
- ETFs: Baskets of stocks and bonds that trade like stocks
There are a number of Roth IRA investment options that aren’t available through most mainstream providers but are allowed under IRS rules. These alternative investments include real estate, promissory notes and precious metals and are available through self-directed IRA custodians.
For more information on self-directed IRAs — including Roth IRAs — and the additional investment options available with these accounts, be sure to read our ultimate guide to Self-Directed IRAs.
“When it comes to IRAs, most of the offerings available at name brands will be fairly ubiquitous — similar setup process, investment options, fees and so on, but it is important to be informed. When it comes to your retirement savings, you don’t want anything unexpected. When working with a name brand, critical information should be easily available online. This is different if you end up exploring options offered by independent financial planners or smaller institutions. Fees and options might be less obvious, which will require that you do a bit more homework.”
— Brian Decker, Founder, Decker Retirement Planning
Who a Roth IRA Is Right For
A Roth IRA good for tax-conscious investors who have high earnings or already have considerable savings. However, it’s also important to meet eligibility criteria including Roth IRA income limits and be willing to follow Roth IRA rules. While Roth IRA contributions aren’t tax-deductible, they allow investors to offset some tax liability during retirement by making after-tax contributions today.
Roth IRAs are also a good option if you think that income tax rates will be higher during your retirement than they are now. In that case, you may end up paying more taxes on traditional IRA distributions than you would pay today on after-tax Roth contributions. In these cases, using a Roth IRA allows you to hedge your bets.
“Tax brackets usually get lower in retirement, but there is no way to predict what tax changes will come in our future. Making after-tax Roth IRA contributions early on can provide you with retirement savings with taxes already paid, leaving you less worried during retirement years. Remember, too, withdrawal of Roth money to fund a project — for example, purchase of a first home — takes on no tax responsibility because the tax is already paid. Withdrawing from a 401(k) brings with it a tax responsibility.”
— Victoria Hitchcock, Audit and Accounting Services Manager, Gorfine, Schiller & Gardyn
Some of the most common cases where a Roth IRA is especially helpful include:
1. Investors Who Want to Save Big with an Additional Retirement Account
If you’re already maximizing contributions to your traditional IRA or employer-sponsored retirement plan, it may make sense for you to put some of your contributions in a Roth IRA to lower your potential tax burden when you take withdrawals during retirement. By setting up a Roth IRA, you can contribute up to $6,000 that will grow and be available for tax-free during retirement.
2. Individuals with Fluctuating Income or High-income Potential
Employees on commission or with fluctuating income can use a Roth IRA to put away more money in years that they maximize their normal retirement plan contributions. If your earnings exceed Roth IRA income limits, you may not be eligible. However, if you earn more than you need to cover expenses and are under the income limit, a Roth IRA is a good way to increase savings.
3. Midsize Business Owners
Many solopreneurs or owners of new businesses already contribute the maximum to traditional IRAs but don’t yet have the revenue to provide retirement benefits to their employees. In these cases, a Roth IRA can be a good temporary account for the business owner to increase their savings until the business is large enough to use a savings incentive match plan for employees (SIMPLE) IRA or 401(k).
4. Tax-conscious Investors
Roth contributions aren’t tax-deductible, but Roth IRA rules allow an account to grow tax-free. In contrast to tax-deferred retirement accounts 401(k)s and other IRAs, which have tax-deductible contributions and taxable withdrawals, Roth IRA withdrawals aren’t taxed during retirement. A Roth IRA can be a terrific way to reduce your tax liability during retirement.
Top Roth IRA Providers
In setting up a Roth IRA, it’s important to choose a provider who fits your needs include cost, goals and investment strategy. For example, passive investors might consider a mutual fund company like Vanguard. If you plan to trade stocks and bonds actively, then you should consider a Roth IRA provider with an online trading platform.
Some of the top Roth IRA providers include:
Vanguard is a very well-established investment management firm. The company is one of the oldest and largest mutual fund companies in the world. With its own line of mutual funds and ETFs, Vanguard is known for providing investors with cost-effective, professionally managed funds.
A Vanguard Roth IRA is ideal for anyone who wants to stick to passive, long-term investing. The company does not have an online trading platform to trade stocks or bonds but is a great Roth IRA provider if you don’t expect more than two or three transactions each year.
Fidelity is one of the largest privately owned financial services companies in the world. It offers a number of different services including banking, securities brokerage and investment management. It also has a line of mutual funds and ETFs as well as offices in most cities around the United States where you can get in-person guidance from financial advisors.
If you think you would benefit from in-person access to a personal financial advisor, a Fidelity Roth IRA may be best for you. Fidelity also offers a host of other services that may help if you have needs separate from your Roth IRA.
Like Fidelity, Schwab is another large diversified financial services company. In addition to Roth IRAs, the company offers a full menu of banking and investment advisory services. It also has offices in many cities- although not as many as Fidelity.
If you already have an account with Schwab or would like to have access to some of its other services, consider setting up your Roth IRA with Schwab. Depending on your individual investment style, Schwab may be a more cost-effective provider than Fidelity.
E-Trade has a long history as an online brokerage firm that lets investors trade quickly and inexpensively. Even today, E-Trade is a great discount brokerage firm that is extremely competitive on costs for investors who want to trade actively in stocks, bonds and other securities.
If you want to trade stocks and bonds online in your Roth, E-Trade is definitely worth considering. Be aware that the cost of trading regularly can eat into your account balance over time, but if active trading is part of your investment strategy, then E-Trade is an ideal Roth IRA provider.
How to Set up a Roth IRA in 4 Steps
Once you’ve decided to set up a Roth IRA, there are certain steps required to follow. Following these steps will ensure that you are eligible for a Roth, that you pick the right custodian and make qualifying contributions. These steps can prevent you from incurring unanticipated taxes or penalties later on.
The four steps for how to set up a Roth IRA include:
1. Determine Eligibility
Once you’ve decided that a Roth may be a good fit for you, the first thing to do is check your Roth IRA eligibility. Not everyone can contribute under Roth IRA rules, so be sure to check income limits above to make sure that you qualify to make Roth IRA contributions.
2. Choose a Type of Provider
The first step to set up a Roth IRA after you’ve confirmed your eligibility is to decide on a Roth IRA providers. Be sure to consider costs, customer service, account features, setup and maintenance costs. Look at each of these factors in light of your investment goals and objectives to decide which is right for you.
3. Open an Account with Your Provider
Work with your chosen Roth IRA company to complete the paperwork to establish your account. There are no forms to file with the IRS for a Roth IRA, so paperwork is usually limited to an account application, disclosure acknowledgments and electronic banking forms. You may be able to select investment options while setting up your account.
4. Make After-tax Roth IRA Contributions
After your account is set up with your ideal Roth IRA provider, the last thing left is to use the account — and that means contributing. Be sure to follow Roth IRA rules and make after-tax Roth IRA contributions. If your earnings exceed Roth IRA income limits for a given year, be sure to adjust your contributions as necessary.
Pros & Cons of a Roth IRA
Roth IRAs have advantages and disadvantages that potential investors need to consider. Roth IRA rules offer tax-free growth and distributions during retirement but contributions aren’t tax-deductible, and account holders can’t withdraw money before age 59 1/2 without paying penalties. Carefully consider the pros and cons of a Roth IRA to decide if one is right for you.
Pros of a Roth IRA
Some Roth IRA pros include:
- Tax-free growth: When you invest in a Roth you don’t pay taxes on any gains or interest earned in the account
- Tax-free withdrawals: Unlike traditional IRAs, simplified employee pension (SEP) and SIMPLEs IRAs, Roth distributions are not taxable as income
- Creditor protection: Money that you put in a Roth IRA is held in trust by your custodian and is protected against creditors or in bankruptcy
- Easy setup and administration: Roth IRAs are very easy to set up and maintain
Cons of a Roth IRA
Some Roth IRA cons include:
- After-tax contributions: Roth contributions can’t be deducted from taxable income
- Penalties for early withdrawals: Withdrawals are prohibited before age 59 1/2 unless you meet certain criteria outlined by the IRS
- Limited investment options: The IRS limits the types of investments that you can make in a Roth, and most Roth providers limit your options even further
- Required minimum distributions (RMDs): Roth IRAs aren’t subject to RMDs during the account holders lifetime, but beneficiaries who inherit a Roth IRA — except a spouse — are required to meet certain RMDs
- Limited eligibility: If your income exceeds Roth IRA income limits you may not be able to contribute the limit to your Roth or contribute at all
Alternatives to a Roth IRA
In addition to Roth IRAs, there are a number of other tax-deferred retirement plans that are commonly used to save for retirement. Among the most common is the traditional IRA, although some employers also use SEP IRAs and SIMPLE IRAs. Employees who have a 401(k) through work may be able to use a Roth 401(k) instead of a Roth IRA.
The two most common alternatives to a Roth IRA are:
Traditional IRA vs. Roth IRA
A traditional IRA is similar to a Roth IRA except that traditional IRAs allow for tax-deferred contributions. Also like Roth IRAs, traditional IRA contribution limits are also $6,000. However, it’s important to understand that the aggregate contribution limit for both a Roth IRA and traditional IRA is $6,000.
Traditional IRAs are ideal for investors who aren’t eligible for a 401(k) at work and want the benefit of tax-deductible contributions. Once you contribute to a traditional IRA, your account grows tax-free. However, withdrawals from the account are treated as taxable income once you start taking distributions.
Roth 401(k) vs. Roth IRA
A Roth 401(k) is like a Roth IRA except that it’s part of an employer-sponsored 401(k) plan and subject to different contribution limits than those allowed in IRAs — $19,000 vs. $6,000. Roth 401(k)s are only available in some 401(k) plans whose plan sponsors have chosen to include the feature.
The Roth 401(k) plan is ideal if you have one available in your 401(k) plan and want to reduce your tax liability during retirement. By splitting your annual contributions between traditional and Roth 401(k) accounts, you get fewer tax benefits upfront but also reduce your income tax liability when you start taking distributions.
For more information on how these retirement accounts compare, be sure to check out our article on the Best Small Business Retirement Plans.
Roth 401(k) vs. Roth IRA
A Roth 401(k) is an account set up within a 401(k) plan. This is different from a Roth IRA, which isn’t employer-sponsored. Unlike a Roth 401(k), anyone can set up an IRA on their own and start contributing, so long as they meet Roth eligibility requirements and follow Roth IRA rules.
Roth 401(k) contribution limits for 2019 are $19,000 — much higher than the $6,000 allowed in a Roth IRA. Roth 401(k) participants who are age 50 or older can also contribute an additional $6,000 in catch-up contributions as opposed to the $1,000 catch-up allowed under Roth IRA rules.
While contribution limits for Roth 401(k)s are far higher than 2019 Roth IRA contribution limits, many Roth IRA rules also apply to Roth 401(k)s. For example, participants can be restricted from making Roth 401(k) contributions based on their income. Also, once account holders reach age 70 1/2, they are still required to start taking minimum distributions each year.
When to Use a Self-Directed IRA
A self-directed IRA is a specific type of tax-deferred retirement account that allows you to invest in a variety of assets that aren’t available with standard IRAs. Some alternative investment options offered by self-directed IRAs include real estate, venture capital, startups, and various stocks and bonds. Both traditional and Roth IRAs can be self-directed, but only select institutions offer this option. Self-directed IRAs offer the same tax benefits as other IRAs and have annual contribution limits of $6,000 ($7,000 if you’re 50+ years old). This can be a good option for individuals who want to combine the power of diverse investment options with the tax protections of a retirement account.
To learn more about setting up a self-directed IRA, reach out to a reputable provider such as Rocket Dollar. Whether you have a Roth or traditional IRA, your investments of choice will continue to grow tax-free. Rocket Dollar has transparent pricing with a $360 registration fee plus $15/month. Opening an account online takes less than 10 minutes.
The Bottom Line
A Roth IRA is a retirement account that allows you to make after-tax contributions and let your account grow tax-free. The tax-free distributions allowed by Roth IRA rules make them a great tool for investors who are already maximizing contributions to tax-deferred accounts or want to lower their income tax liability during retirement.