One of the most recent additions to list of retirement investment options, the Roth IRA, was established just over 20 years ago by the Taxpayer Relief Act of 1997.  

While there are many similarities between Roth and traditional IRAs, there are many important differences to keep in mind when deciding how to invest.

Here’s what you need to know about the Roth IRA:

1. Roth IRA Contributions Are Not Tax-Deductible, Grow Tax-Free

Unlike contributions to traditional IRAs or 401(k)s, contributions to a Roth IRA are made post-tax – that is, after you already paid taxes on that income. But while contributions are not tax-deductible, the growth on these contributions is tax-free.

2. You Can Withdraw Contributions Out at Any Time

While contributions to tax-deferred accounts like a traditional IRA typically can’t be withdrawn without paying taxes and a penalty, withdrawals of Roth contributions (but not earnings) are tax- and penalty-free at any time. If your financial plan involves relying on your retirement savings to get you through a pre-retirement financial emergency, you should have a Roth IRA as part of your portfolio.

3. …But Not Your Earnings

While you can withdraw contributions easily, Roth IRA earnings are subject to withdrawal restrictions. In general, the only way to avoid taxes and penalties is to be over 59 ½ and the Roth IRA account has to be at least five years old. If you’re 59 or under, there are qualifying exemptions that may allow you to avoid withdrawal penalties, but you will still be subject to taxes if you had the account for less than five years.

4. There Is No Age Limit For Contributions

As you approach and enter retirement age, the government begins to curtail your ability to contribute to tax-deferred accounts. With a traditional IRAs, for example, you’re no longer able to make contributions after you turn 72. With a Roth, you can keep contributing as long as you’re able, regardless of age.

5. And There Aren’t Any Distribution Requirements

Because it wants to get its hands on all that deferred tax revenue, the government forces retirees to start taking distributions from tax-deferred retirement accounts after they turn 72. This is not the case for Roth IRAs, which are not subject to any distribution requirements.

As a result, it’s possible to keep making contributions to your Roth IRA until the year of your death without ever taking out a single dime. And as long the account for at least five years and named a beneficiary, the full amount would be inherited tax-free.

6. But Annual Contribution Limits Are Fairly Low

The one significant downside of the Roth IRA is that you can’t contribute all that much. For 2020, you can contribute up to $6,000 to your Roth IRA. If you’re 50 or above, you can contribute another $1,000 for a total of $7,000.

If you’re married and file taxes jointly, you can establish a Roth for a non-working spouse—effectively doubling the amount you can contribute within a tax year. Over time, this can add up to significant savings for you and your spouse.

7. And There Is an Income Cap

Though the only requirement for opening a Roth or making contributions is that you need to have income, you can’t have too much income, either.

This is because eligibility to contribute to a Roth IRA begins to phase out at higher income levels. For 2021, contribution eligibility begins to phase out at $198,000 for joint filers and $125,000 for single filers. The limit drops to $0 at $207,000 and $140,000, respectively.

8. Earn too Much? Sneak in the Back Door.

For the time being, there’s a loophole that allows high-earners to contribute to a Roth by converting a traditional IRA to a Roth using what is known as a “back-door conversion.”

Of course, since Uncle Sam always has his hand out, you’ll have to pay taxes on the amount of conversion. It may also push you into a higher tax bracket in the year of the conversion. Beyond that the back-door funds in your Roth are considered earnings, not contributions, so you’ll want to have to wait five years from the date of conversion to withdraw them without paying penalties. In all, if you’re interested in executing a backdoor conversion, it should be done as part of a strategic retirement plan that takes these details into consideration.

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Alli Thomas

Alli Thomas has worked in the financial services industry for nearly 20 years, with a focus on retirement-related investing. She began her career as a FINRA-licensed participant-services call-center associate at Vanguard, and then moved to Principal Financial Group, where she worked closely with employers, assisting with retirement plan set-up and design, selecting appropriate plan investment offerings, and maximizing employee participation through targeted education campaigns and enrollment meetings. Alli has also worked as a qualified 401(k)administrator and registered investment advisor for several small investment firms. She now writes about all things investment- and finance-related, leveraging her extensive experience and passion for retirement planning to help investors make well-informed financial decisions.

Retirement Planning