Basics of a ROTH IRA Account
In the universe of goal-based financial planning, reaching the point where earning an income is no longer necessary to sustain a certain lifestyle is one of the most substantial objectives an individual can aim to achieve. To successfully reach retirement, it is necessary to set aside a portion of earnings along the way. Some individuals are able to accumulate retirement savings through an employer-sponsored plan, such as a 401(k) or 403(b); others utilize supplemental retirement vehicles as a means to reach their financial objectives. One of those supplemental vehicles not tied to an employer is a ROTH IRA.
What is a ROTH?
The IRS defines a ROTH IRA as a post-tax individual retirement account that certain individuals have the opportunity to use in an effort to set aside money specifically for retirement years. A ROTH IRA differs from an employer-sponsored plan in that it is individually held and managed by the account owner. Additionally, contributions to a ROTH are not made through paycheck deferrals but rather are established as a direct withdrawal or other form of payment from an individual’s checking or savings account.
ROTH IRA accounts were originally established to offer a means to supplement retirement savings for individuals who need or otherwise want tax-free income throughout their non-working years. Gains from investment performance and interest earned on funds held within a ROTH IRA account grow each year on a tax-deferred basis, which means account holders have no need to report or pay taxes on any earnings within the account. When funds are withdrawn in part or in full during retirement, no taxes are owed on previous investment gains or the initial contributions made. Employer-sponsored plans that offer pre-tax savings are fully taxable when withdrawn in retirement, making the ROTH a smart way to create a blended tax base throughout retirement.
Why You Should Care
A ROTH IRA works as a sound solution to retirement planning needs in that it provides tax-free income – offsetting the tax burden inherent to pre-tax retirement funds accumulated throughout the years in a 401(k), 403(b) or traditional IRA account. The ability to generate tax-free income allows individuals the ability to have accumulated funds work that much harder in terms of purchasing power over the long run.
For instance, accumulating $100,000 within a ROTH IRA means that the account holder has access to the full amount without a tax liability, as long as the distribution is in line with certain guidelines. That same $100,000 accumulated within a pre-tax savings vehicle would be worth only $80,000 once distributed to an individual, assuming a tax rate of 20%. This is because any withdrawals from a pre-tax savings vehicle are treated as ordinary income in the eyes of the IRS and therefore fully taxable when money is taken out. A ROTH account is beneficial in offsetting this pre-tax burden for those who plan ahead.
As with most tax-benefited accounts, a ROTH IRA has some limitations in terms of eligibility. Individuals must fall under a certain threshold of total household earnings to be able to contribute to a ROTH. For individual taxpayers, that income limit begins at $117,000 and fully phases individuals out at $132,000 in total earnings. For married contributors, restrictions begin once total household earnings reach $184,000, with full ineligibility happening at $194,000.
Any contributions that are made to a ROTH once an individual has passed these earnings thresholds is penalized if it is not removed within the year the contribution was made. Worry not, though – contributions made into a ROTH IRA while earnings were lower than the income limits can stay within the account and may continue to earn interest or investment gains for as long as the account holder wishes.
ROTH IRA accounts are powerful retirement savings vehicles for individuals who qualify to make contributions, but there is a cap on how much money can be stashed away within this type of account. First, individuals must have earned income – that is, money from business ownership, 1099 pay or a conventional employer – in order for ROTH contributions to be made.
As long as money is earned and is under the previously mentioned income limits, contributions up to $5,500 can be made to a ROTH IRA throughout the tax year. While individuals have the opportunity to have multiple ROTH IRA accounts with different banks, investment advisors or other custodians, the cumulative contribution amount cannot exceed $5,500 among all accounts. For individuals who are above the age of 50, an additional catch-up contribution of $1,000 can be made each year, above the normal $5,500 limit.
Getting Money Out of a ROTH
As with employer-sponsored plans and traditional IRA accounts, contributions, gains or a combination of the two cannot be withdrawn from a ROTH IRA until the account holder reaches the age of 59 ½. Should a distribution be taken prior to that time that does not qualify as a penalty-free withdrawal, account holders may be taxed on earnings and a tax penalty of 10% may be assessed on the amount withdrawn.
However, the ROTH was established with far more flexibility than other retirement savings vehicles when it comes to penalty-free withdrawal scenarios. Account holders have the opportunity to take money from a ROTH IRA for the following situations, free of any tax or penalty:
- Up to $10,000 withdrawn for the purpose of purchasing your first home
- Account holder becomes permanently and totally disabled
- Paying medical insurance premiums during unemployment
- Paying for unreimbursed medical expenses that exceed 10% of your adjusted gross income
- Distributions are taken for the purpose of paying higher education expenses
- Distributions are part of a series of equal and substantial payments
While a ROTH IRA should be used primarily as a long-term savings vehicle, the opportunity to take money out of a ROTH account prior to retirement age is attractive to some savers. Money withdrawn from a ROTH IRA for these qualified distributions does not need to be repaid to the account at any time, as it would with a loan from an employer-sponsored plan.
A ROTH IRA account is a great way to save for the substantial goal that is retirement in a tax efficient manner, but it is important to understand the limitations. Only individuals who earn under a certain amount of income are eligible to contribute to a ROTH IRA account, and total contributions are capped at $5,500 for individuals under 50 and $6,500 for those over 50, per year. Despite these restrictions, a ROTH IRA can provide tax-free, penalty-free funding for some of life’s major expenses above and beyond retirement, including help toward a first-time home purchase, covering education costs, and offsetting unreimbursed medical expenses. As long as the limitations inherent to a ROTH IRA are understood, individuals can utilize this type of account as an alternative or a supplement to employer-sponsored plans and traditional IRA accounts during their working years.