What Is a Roth IRA? Roth IRA Investment Options

Looking for different investment options? Heard of a Roth IRA and wondering what is it and how it works? This article will discuss everything you need to know about a Roth IRA, how it works, and the investment options available for you.

Keep reading to dig the valuable info

1. What is a Roth IRA?

Roth IRA is like a tool or vehicle designed to help people save for retirement.

A Roth IRA is an Individual Retirement Account (IRA) under United States law that allows qualified withdrawals on a tax-free basis. However, there is certainly an eligibility criterion as certain conditions have to be satisfied. In simple words, it offers tax-free growth and tax-free withdrawals on retirement when certain conditions are met.

Although Roth IRAs are similar to traditional IRAs, the main difference lies in how theyre taxed. Roth IRAs are funded with after-tax dollars while the contributions are not tax-deductible but once you start withdrawing funds, the money is tax-free. On the other hand, the traditional IRAs are made with pretax money and you get a tax deduction on your contribution.

1.1. Basic facts to Know About IRAs

Perhaps youve heard about IRAs but there are some basic facts that you may need to know. Having sufficient knowledge will help you reach your retirement goals and to get started, take a look at these basic facts

a. IRA Limits: There are annual limits as to how much you can contribute to an IRA. For 2020 and 2021, the Internal Revenue Service allows as much as $6,000/year for people younger than 50 years and $7,000/year for 50 years or older. Also, you must have earned that much to contribute to an IRA and it can also include your spouses income.

b. Types of IRAs: Before you invest, you should know that there are two different types of IRAs: traditional and Roth. In a traditional IRA, you dont have to pay taxes on your income until you start taking required mandatory distributions while the Roth IRA requires you to pay taxes at your current tax rate but allows your income to grow tax-free.

c. IRA Costs: You will need to find a bank or an investment broker if you want to open an IRA as the cost may differ. Some brokers offer no-fee IRAs while others will charge a yearly management fee other than the commission charged for buying and selling within the account. Look for a no-fee IRA or work with a broker that keeps the fees minimum.

d. IRA Eligibility: There are eligibility criteria if you want to invest in IRAs and may differ from type to type. With the traditional IRA, the deductions for your contribution amounts are limited while with the Roth IRA, the contributions are made with after-tax money. A Roth IRA can be a better choice if your traditional IRA isnt tax-deductible.

2. How Roth IRAs Work and How to Start One?

A Roth IRA works just like a traditional IRA with the distinction that you contribute money into it after-tax. Also, you can only contribute to this type of IRA if your adjusted gross income (AGI) is less than a certain amount. However, it allows you to contribute to assets of your choice such as mutual funds, stocks, or bonds.

The money you contribute to the Roth IRA is not tax-deductible but the earnings will grow tax-free. For the tax years 2019, 2020, and 2021, you can contribute to your Roth account lesser of your taxable income for the year or $6,000 and $7000 if you are 50 years old or older. Also, you dont need to make the entire contribution at once but distribute it into smaller portions.

Still, confused? The following points might help

① With a Roth IRA, you have already paid the taxes on the money you contribute so your gains are tax-free.

② Any withdrawals you make from your account are penalty-free if youre at least 59 and half years old and have your account running for at least five years.

③ You are not required to take minimum distributions starting at age of 72 and you can also avoid the early withdrawal penalty for some situations.

Opening a Roth IRA

For opening a Roth IRA, you will need to find an institution that has received IRS approval to offer IRAs. These institutes may include banks, federally insured credit unions, brokerage companies, or savings and loan associations. Most individuals prefer opening a Roth IRA with brokers as they provide quite good services.

There are two basic documents that you will need to provide to the IRA broker or bank

a. the IRA disclosure statement

b. the IRA adoption agreement and plan document

The above-mentioned documents provide an explanation of rules and regulations and the IRAs operate under these rules and regulations.

Heres how you can start your Roth IRA

1) You can open your Roth IRA at nearly any bank or brokerage firm, either online or in person.

2) Opening a Roth account is extremely simple as there are just two forms you need to complete.

3) You need to have your Social Security number handy along with the Social Security numbers and address of any potential beneficiaries.

3. Roth IRA Investment Options and Eligibility Criteria

A Roth IRA contains investment options in securities such as common stocks and bonds and can also be an individual retirement annuity. However, just like other investments, there are some eligibility and filing status requirements.

Check out the following table to understand your eligibility for a Roth IRA

Category

Income Range for 2020 Contribution

Income Range for 2021 Contribution

Single, head of household, or married filing separately without living with a spouse at any time during the year

Full: less than $124,000

Partial: From $124,000 to less than $139,000

Full: Less than $125,000

Partial: From $125,000 to less than $140,000

Married and Filing a joint tax return

Full: Less than $196,000

Partial: From $196,000 to less than $206,000

Full: Less than $198,000

Partial: From $198,000 to less than $208,000

Married, filing a separate tax return, lived with spouse at any time during the year

Full: $0

Partial: Less than $10,000

Full: $0

Partial: Less than $10,000

(The chart shows the figures for 2020 and 2021)

4. Things You Need to Know Before Starting

There are certain things you must know before you put your money into a Roth IRA.

a. Money You Can Put into a Roth IRA: Talking about the year 2020, the maximum contribution is $6,000 per year but it increases to $7,000 per year if you are 50 or older. Also, the contribution eligibility is available to those who have earned income.

b. Roth IRA Account for Anyone and Everyone: If you want to set up a Roth IRA account for your spouse and kids, you can do so under a spousal IRA. You can do this even if your spouse has no earned income and make a contribution to your account for both you and your spouse.

c. You May Get Phased Out: Yes if you exceed the allowed limit by IRS while contributing to a Roth IRA, you wont be able to contribute more. If your income exceeds a certain level, you can just contribute to a traditional IRA but it wont be tax-deductible.

d. The Backdoor Roth IRA: The name backdoor Roth IRA comes from the fact that it starts as a contribution to a traditional IRA. The idea behind this kind of IRA is that you make a full contribution to a traditional ITA on a non-tax-deductible basis.

e. Roth IRA Contributions: As far as the contributions to Roth IRA are concerned, they can be withdrawn at any time as no tax is deductible. However, a 10% early withdrawal penalty may apply if you withdraw funds before turning 59 and a half years old.

5. Advantages of Considering Roth IRAs as Investment

Well, there are many benefits of considering Roth IRAs as your investment option. Weve discussed some major advantages that you can enjoy:

1. Tax Savings: As you pay taxes on your income in the current rather than in the future, you can save yourself from paying higher in the future.

4. Easy Withdrawals: A Roth IRA allows you to withdraw the contributed money at any time with no taxes or a penalty but you may be taxed if it is from your investment earnings.

5. Flexibility: It is up to you that when and how much you want to contribute as you can either contribute the whole amount or split it up over many months.

6. Tax-Free Distributions: You can take distributions with your Roth IRA account without paying federal taxes when you are 59 and a half years old.

7. No Age Limit: There is no age limit to open a Roth IRA and you can start it at any age given that you have earned a certain amount of income.

Are you ready for a Roth IRA?