Your smart and simple guide to Roth IRA

Aman Saxena
11.18.20
8 minute read

No matter how old you are, saving and planning for retirement is a smart choice. But trying to figure out what to do and how to go about it can be confusing.

One of the many terms you have probably come across is a Roth IRA.

Let’s breakdown the basics of a Roth IRA and how it works. Read on to see if this flexible retirement vehicle is worth considering within your retirement plan.

📝 Table of contents

What is a Roth IRA?

Named after Senator William Roth in 1997, a Roth IRA is a way for people to save for retirement using their take-home salary, as long as they meet the requirements.

You can contribute to a Roth IRA every year as a working individual or married couple. And that money stays in the Roth IRA account until you draw on it in retirement. The biggest perk is that your withdrawals from a Roth IRA are tax free at that time in the future.

So to make it simple, you can put your after-tax income into a Roth IRA now, and let it grow. Then, you can take the money in the account as a qualified distribution when you are retired and not have to pay taxes on the amount.

🎯 Quick Take: Roth IRA
  • If you file single and make less than $139,000
  • If you are married and make less than $206,00
  • Contributions made from your after-tax income
  • Withdrawals in retirement are tax-free
  • Max contribution amount is $6,000 in 2020
  • Additional $1,000 for anyone above age 50
  • Contributions can be invested

You might be thinking, wait what is an IRA account then?

What is an IRA account?

IRA stands for Individual Retirement Account. You can open an IRA at a bank or an approved financial institution.

An IRA is a way to help individuals and families save for retirement. An IRA typically can involve contributing money to an account that you will draw on later when you are in retirement.

But there are different types of IRAs you can come across:

  • Traditional IRA
  • Roth IRA
  • Rollover IRA
  • SEP

Let’s focus on the top two IRA options.

Money deposited into a Traditional IRA is tax exempt at the time you are putting it in.

The money deposited into the Traditional IRA can be invested in banking and investment options available with your IRA-provider, so it can grow.

Then when you retire and are drawing income from your IRA, the money comes out of the IRA account and is taxed as income. The logic is that retirees are assumed to be at a lower tax bracket and so will pay less in taxes on the IRA-drawn income.

What's the difference between a Roth IRA and an IRA?

The main differences between a Roth IRA and a Traditional IRA is mainly around taxes, age and withdrawals.

💸 A Traditional IRA is tax deductible at the time of contribution.

When you put money into an IRA that year, you can write that off on your taxes. But you will pay taxes when you take the income in retirement.

With a Roth IRA, the amount you put in the account that year is not tax deductible. Which means it is assumed you have already paid taxes on that income. So in that case, you will not pay taxes on the income when you take it in retirement.

But there are more differences.

With a traditional IRA, you must be below the age of 70 ½ to open and contribute to it. Plus, you are required to take a minimum distribution, or RMD, at age 72. If you don’t, you are going to get hit with a penalty.

With a Roth IRA, you can keep the money in the account as long as you like. There are no requirement minimum distributions with a Roth IRA. You can continue to contribute to a Roth even in your 70s.

Do I qualify for a Roth IRA?

As long as you have taxable income coming in, you can open a Roth IRA account. For young people below the age of 18, a custodial account can be opened by their parents.

But the Roth IRA is not for everyone, and you can only qualify for it if you meet the income requirement as per your filing status with the IRS.

The income requirement is based on your Modified Adjusted Gross Income, or AGI, which is your household’s gross income including your tax deductions.

You are...Maximum Modified AGI to qualify
A Married Couple filing jointly$205,999
Married but filing separately and not living with your spouse$138,999
Single$138,999
Qualifying widower$205,999

Double check with your tax professional as certain amounts closer to the limit will only allow a partial amount contribution.

You can have a Roth IRA even if you are on an existing employer-sponsored retirement plan.


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How does a Roth IRA work?

First, a Roth IRA can only be opened as a Roth IRA.

So a SEP IRA or a simple IRA can’t be called a Roth IRA.

It is possible to roll a Traditional IRA to a Roth IRA after some time.

A Roth IRA can be an account or an annuity. Once opened and deposited, money in a Roth IRA can be held in cash, mutual funds, stocks, bonds, CDs, or other investment vehicles like exchange traded funds.

💵 How your money is put to work in your Roth IRA is dependent on your goals, your risk profile and your time horizon for retirement.

How to Open a Roth IRA

When you want to open a Roth IRA, you have to go to an institution that is approved by the Internal Revenue Service (IRS) to provide IRAs. That means that Roth IRAs can be opened by a:

  • Bank
  • Financial institution
  • Brokerage company
  • Life insurance company
  • Mutual fund
  • A licensed individual broker

Also credit unions that are federally insured or savings and loans associations may be able to offer them as well. One of the first places to check if a Roth IRA is available is your current bank.

ℹ️ As long as you are over the age of 18 and are earning working income, you can open a Roth IRA at any time.

ℹ️ It is also possible to have multiple Roth IRA accounts.

But the Roth IRA works on the tax-calendar so your max contributions for that year must be made before your tax-filing deadline. After which the clock restarts, and you can contribute the maximum amount allowed until the following year’s deadline.

You can open a Roth IRA online with some providers, but also in person.

⚠️ You will need to provide your personal information, including your employment and financial details like your Social Security Number, and assign beneficiaries

Before you finish, you will need to sign an individual Roth IRA disclosure statement and custodial agreement. There may be additional documents to sign, which will be provided by the institution.

The investment options that are available and that match your goals should be considered before choosing an institution to go with. Different providers will offer different investment options within your Roth IRA so finding the right asset mix will be important.

Also, be sure to check what the provider’s minimum account balance is before signing up.

Is my Roth IRA safe?

One thing to keep in mind is that at a bank or FDIC-covered institution, the FDIC is only up to $250,000, in total. So the sum of all of your accounts and deposits, including a Roth IRA at the bank, would need to fall below the FDIC limit to be insured.

As for non-bank deposit Roth IRAs that are more tied to the investment markets, there is always a risk that your account may move with market fluctuations.

For better or for worse.

That is why it is important to get consultations from a financial professional to assess your risk appetite, growth horizon and income needed at retirement to find the investment vehicles that are right for you and your Roth IRA.

Contributing to your Roth IRA

You can contribute to your Roth IRA every year, but there are contribution limits.

For 2020, the most you can contribute is $6,000 per year if you are below the age of 50.

If you are above 50, that amount increases to $7,000. The additional $1,000 is called a catch-up contribution.

💵 You can also continue to contribute to your Roth IRA even past age 70 ½ as long as you are earning income.

The limits for Roth IRA contributions have the option to change every year so keep on eye out for any increases or decreases in the limit.

Contributions can only be made from cash, and not as securities or assets. Same goes for other types of income earned.

You can’t make contributions from property maintenance or rental income, interest income, pension income, annuity income or investment dividends or gains.

What about a Spousal Roth IRA?

You can help and support a non-working spouse for their retirement savings with a Spousal Roth IRA.

To qualify, you have to be a couple that files a joint federal tax return, and one spouse is earning an income.

The Spousal Roth IRA works the same way as a normal Roth IRA- where the working spouse can contribute a maximum of $6,000 a year for their spouse if they are below 50 years old. That increases to $7,000 a year if the spouse is over the age of 50.

You will also need to make sure you meet the income requirement as a joint married couple to be eligible for the Roth IRA.

Withdrawing from your Roth IRA

Technically, you can withdraw the money you contributed at any time from a Roth IRA. But if you withdraw money before the age of 59 ½ , you will pay a 10% penalty on the withdrawal.

What is a Qualified Distribution?

Now if you are 59 ½ or above , you can withdraw your contributions, and earnings, as a qualified distribution, without the penalty, as long as your Roth IRA has been open for at least 5 years. Also called, the 5-year rule.

ℹ️ A Qualified Distribution is money taken from a Roth IRA when you are at least 59 ½, and the Roth IRA has been open for at least 5 years

The 5 year rule also applies to Roth IRAs that are inherited or Roth IRAs that were converted from a traditional IRA.

What about withdrawing your earnings on your contributions in the account?

If you are below 59 ½ and the Roth IRA has been open for at least 5 years, you will have to pay taxes on the earnings you are withdrawing, on top of the penalty fee.

Age10% PenaltyIncome taxes
Below 59 ½YesOnly on earnings
Above 59 ½NoNo (unless the account is less than 5 years old)

There are exceptions however. A withdrawal from a Roth IRA can avoid the taxes and penalties if you are below the age of 59 ½, if the money is being used for:

  • Purchasing or rebuilding a first home
  • Due to a disability as recognized by the IRS
  • Sending to the owner’s beneficiaries or estate

What is a Non-Qualified Distribution?

A non-qualified distribution is a withdrawal from your Roth IRA that you take when:

  • You are younger than 59 ½
  • Your account is less than 5 years old
  • Doesn’t meet any of the exceptions

Sources:

All sources checked as of 18 November, 2020


This publication is provided for general information purposes only and is not intended to cover every aspect of the topics with which it deals. It is not intended to amount to advice on which you should rely. You must obtain professional or specialist advice before taking, or refraining from, any action on the basis of the content in this publication. The information in this publication does not constitute legal, tax or other professional advice from TransferWise Limited or its affiliates. Prior results do not guarantee a similar outcome. We make no representations, warranties or guarantees, whether express or implied, that the content in the publication is accurate, complete or up to date.

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