But what is a Roth IRA, how does a Roth IRA work and what types of assets can you invest in through your account? Our crash course on Roth IRA account options will help you learn more.
What is a Roth IRA?
A Roth IRA is an individual retirement account allowing individuals to save for retirement while potentially avoiding taxes on their earnings and withdrawals. Opening a Roth IRA is relatively simple, and you can invest in many of the same assets as a 401(k) account. Roth IRAs also have tax benefits like a 401(k), and you can maintain both accounts simultaneously.
How Does a Roth IRA Work?
Roth IRA accounts work similarly to other major retirement accounts, except that these accounts are self-directed. After opening an account with a licensed broker, individuals may choose qualifying assets from the broker's offerings to add to their account.
Are Roth IRA contributions taxed? Contributions to a Roth IRA are made with after-tax dollars, meaning you cannot deduct your contributions the year you make your deposits. However, when you withdraw the money in retirement, you will not need to pay taxes on your distributions. This taxation schedule is the primary difference between Roth IRAs and traditional IRA options.
The Roth IRA was the vision of a U.S. Senator from Delaware, William Roth Jr., to combat the country's low savings rate and make long-term investing more appealing, particularly to younger investors. From 2000 to 2016, deposits in IRA Roth account options grew from $77.6 billion to approximately $660 billion.
When considering a Roth IRA vs traditional IRA, consider your current income tax rate and how it's likely to compare to your income in retirement. For example, younger investors may want to consider Roth IRAs.
Types of Investments Allowed in a Roth IRA
The Internal Revenue Service (IRS) has rules governing what types of investments can go in an IRA, including a Roth IRA. In addition to IRS rules, individual custodians may also have Roth IRA investment restrictions. The following are some of the most common assets you can invest in after learning how to open a Roth IRA.
Mutual Funds
A mutual fund is an investment vehicle that pools money from multiple investors to purchase a portfolio of stocks, bonds or other securities. A professional portfolio manager manages the funds, investing the money according to the fund's goal.
Stocks
Stocks are individual company ownership shares trading on major exchanges. Some Roth IRA account providers allow you to invest in individual shares of stock through your IRA rather than through a mutual fund investment. While buying shares of stock doesn't include the fees you'll see with mutual funds, it also exposes your retirement funds to additional risk.
Bonds
A bond is a fixed-income investment in which an investor loans money to a borrower (like a company or government entity) for a set period. In exchange, the borrower pays the investor interest at a predetermined rate and promises to repay the principal (the loan's original amount) when the bond matures. Bonds are more stable Roth IRA investments when compared to mutual funds and stocks because they hold a guaranteed value.
Certificates of Deposit (CDs)
A CD is a savings account that typically offers a fixed interest rate and a fixed investment term. When you open a CD, you agree to keep your money deposited in the account for a period ranging from a few months to several years. In exchange, the CD provider releases the CD with interest when it matures. CDs are another option for a low-risk investment, as they are FDIC-insured up to $250,000 per depositor per insured bank.
Money Market Funds
Money market funds are mutual funds that invest in short-term, low-risk securities, such as government bonds, certificates of deposit and commercial paper. A money market fund aims to provide investors with a stable, low-risk investment option that offers higher returns than a traditional savings account or checking account.
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Account type
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Traditional IRA
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Roth IRA
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Maximum contribution for 2023
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$6,500 with $1,000 in catch-up contributions
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$6,500 with $1,000 in catch-up contributions
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Tax benefits
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Deduct contributions the year you make them from federal income
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Take distributions tax-free
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Required distributions
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Begin at age 73
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None
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Eligibility for a Roth IRA
To be eligible to contribute to a Roth IRA, you must meet certain income requirements. If you do not meet the requirements to open a Roth IRA because your income is too high, you may be able to use a backdoor Roth IRA to circumvent income limitations.
Income Restrictions
Roth IRA income limits for 2023 are based on your household's modified adjusted gross income (MAGI). Your MAGI is your annual gross income with select tax credits and deductions applied.
If your MAGI is less than $138,000 as a single filer, you can contribute up to the total amount to your Roth IRA, up to $6,500 or $7,500 if you're age 50 or older. You can only contribute a partial amount if your MAGI is between $138,000 and $153,000. Beyond $153,000, you are no longer eligible to open a Roth IRA. However, you can still use a traditional IRA to gain immediate tax benefits.
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MAGI
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Roth IRA contribution eligibility
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Less than $138,000
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Fully eligible
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$138,000 to $153,000
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Partial contribution
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Greater than $153,000
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Not eligible
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You may circumvent IRA income limits using a backdoor Roth IRA strategy. During a backdoor Roth transaction, an investor opens a traditional IRA, makes deposits into the account and then converts the account to a Roth IRA. There may be penalties associated with opening a backdoor Roth IRA, so consult with a professional versed in your financial situation before opening an account.
No Age Restrictions
There are no age restrictions on Roth IRAs, nor are you required to take money from the account at any point. Unlike traditional IRAs, which have a requirement to start taking distributions at age 72, Roth IRAs have no age limit for contributions or withdrawals.
Contribution Limits
Contribution limits on Roth IRAs are the same as traditional IRAs. You will qualify to contribute up to $6,500 annually if you're under 50 and up to $7,500 past age 50. Your contribution limit will reduce proportionally if your MAGI is more than $132,000 annually. You can use this Roth IRA calculator from MarketBeat to estimate your Roth returns over time.
Roth IRA Rules
Tools like our MarketBeat retirement calculator can help you calculate the amount of money to divert to each tax-advantaged account to get the most out of your retirement funds. Before you learn how to start a Roth IRA and start allocating funds to each investment, familiarize yourself with the following IRA contribution and withdrawal rules and regulations.
Withdrawal Rules
Unlike a traditional IRA, you do not have to take withdrawals from your Roth IRA past age 73. However, you will face similar penalties as a traditional IRA if you withdraw from your account early.
When you turn 59 1/2, you can begin taking withdrawals from your account without penalties. If you withdraw money before this age, you may pay an early withdrawal fee of up to 10%.
Contribution Rules
There are few contribution rules when choosing assets for an IRA. Depending on the account's custodian, you can invest in everything from stocks trending in the media to mutual funds and even gold with specialized providers. Note these asset options before you decide where to open your IRA.
Conversion Rules
An IRA conversion involves transferring funds from a traditional IRA or a pre-tax retirement account, like a 401(k), into a Roth IRA. While converting these funds will allow you to avoid paying taxes on them when you withdraw according to IRA rules, anything converted will be taxed as normal income.
No income limits exist on converting a traditional to Roth IRA. However, if you are converting funds from a pre-tax retirement account, you must meet the eligibility requirements for contributing to a Roth IRA. There is also no limit on the total amount of funds you can convert if you prepare for the tax implications. Consider consulting with a tax professional to learn more about how you'll save in retirement versus converting funds now.
Five-Year Rule
The five-year rule determines whether you qualify for tax-free distributions from a Roth IRA. To qualify, both of the following must be true:
- You're at least age 59 1/2
- Your first contribution to the account was at least five years ago
Consider the five-year rule when determining whether to open a Roth or traditional IRA.
Pros and Cons of IRAs
IRAs provide a range of benefits and drawbacks when deciding how to invest your limited capital. Calculate Roth IRA potential returns before choosing which type of account to open, and familiarize yourself with both pros and cons.
Pros
IRAs offer a customizable way to save on taxes while investing more toward your future.
- Tax advantages: One of the biggest benefits of IRAs is their tax advantages. Traditional IRAs offer tax advantages the year you make contributions, while Roth IRAs offer tax-free growth.
- Flexibility: IRAs offer flexibility regarding investment options, allowing you to choose from a wide range of stocks, bonds, mutual funds and other assets.
- Additional benefits: You can hold an IRA in addition to a 401(k), making it an excellent choice for those who regularly max out their employer-sponsored IRAs.
Cons
While IRAs offer tax benefits, there may be better choices for anyone needing liquid funds access:
- Early penalty fees: If you deduct money from your IRA before age 59 1/2, you may face an early withdrawal fee of up to 10%.
- Income limitations: While traditional IRAs do not have income limits, Roth IRAs do.
How to Get a Roth IRA
Now that you understand the benefits of opening a Roth IRA, follow these steps to start and fund your account.
Step 1: Determine your eligibility.
Before opening a Roth IRA, determine your eligibility and how much you can contribute annually to your account. Consider a traditional or SEP IRA if your MAGI disqualifies you from opening a Roth IRA.
Step 2: Choose a custodian.
Once you know the type of account you need, choose a financial institution to manage your account. Examples of common IRA broker options in the United States include Charles Schwab, Vanguard and Fidelity. Complete an application with your broker, and wait for your account to be approved.
Step 3: Fund your account.
After opening your account, link a funding source that you’ll use to add money to your IRA. Most IRA providers allow you to add funds using a direct bank transfer or wire transfer. Transfer funds to your account in preparation of your first buy order.
Step 4: Choose which assets to buy.
Decide how you want to invest your contributions. Many financial institutions offer a variety of investment options, such as mutual funds, ETFs and individual stocks. For example, if you open an account through Vanguard, you’ll have access to a wide selection of mutual funds. Take a look at your broker’s list of available assets, and decide how you want to invest your funds up to the IRS limit.
Is a Roth IRA Right for You?
Roth IRAs are an exceptionally useful tool that allows you to save more towards retirement and customize your benefits. However, it's important to remember that Roth IRAs have rules and restrictions, such as contribution limits and withdrawal rules. Consider both the pros and cons of both major types of accounts thoroughly and consider consulting with a tax professional to learn more about the most beneficial option for you.
FAQs
Before leaving to browse a media sentiment stocks list or a list of major cap companies, get these last-minute answers to common Roth IRA questions.
What is better, a 401(k) or Roth IRA?
A 401(k) can be beneficial if your employer offers matching contributions and you want to lower your taxable income. A Roth IRA may be better if you want tax-free withdrawals in retirement or if you think your income will be higher when you retire. However, you can have both types of accounts as a single investor. Learn more about other niche IRAs, like gold IRAs, before you invest.
How does a Roth IRA work?
A Roth IRA is a type of individual retirement account that allows you to save money for retirement on a post-tax basis. This means that you contribute money to your Roth IRA with after-tax dollars, and your contributions and earnings grow tax-free. Once you reach age 59 and a half, you can make withdrawals from the account without paying taxes.
What is a disadvantage of a Roth IRA?
One disadvantage of a Roth IRA is its early withdrawal fees. If you withdraw money from your Roth IRA before age 59 and a half, you may face penalties of up to 10%.
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