What is a Roth IRA, and is a Roth IRA the best way to save for my retirement?
Even the basics in financial planning aren’t always so basic, and the basics of IRA plans, is one of those times.
IRA stands for Individual Retirement Account. As you may imagine, that means it is an account for an individual (versus a group like a 401k plan is for) to use in order to save for retirement. As an enticement to actually save for your own retirement, the government gives you tax advantages for using an IRA for retirement planning. As a way to keep you from pulling money out for other things besides retirement, there is a penalty if you use it for something else.
Roth IRA versus Traditional IRA
With a traditional IRA, or just IRA, you get a deduction from your taxes today, unless your income is too high, and tax deferred growth on the money in the account. When you start taking the money out, you owe taxes on both the contribution and the gains. (If you earn too much money to take the tax deduction on your contributions, then you do not have to pay taxes on those funds again when you withdraw them.)
With a Roth IRA, you get no tax deduction today, but the earnings grow tax-free inside the account, and you pay no taxes on either the withdrawal, or the earnings when taken in retirement.
Both types of IRAs require you to be age 59 1/2 to make a qualified non-penalized withdrawal, unless you meet certain, very specific exceptions. If you are not 59 1/2 years old when you withdraw money, it will be subject to both ordinary income tax and a 10 percent penalty.
Roth IRA Rules
There are Roth IRA income limits that prevent certain high-income tax payers from contributing to a Roth IRA. Although such taxpayers can do a Roth conversion to convert a regular IRA account into a Roth IRA account.
After that, the most important thing to understand about a Roth IRA and the rules for Roth IRAs is that you do not get a tax deduction for contributions. That means any money you put into a Roth IRA has already been taxed and will not be taxed again. The other thing you must understand is that this is NOT true for any dividends or gains in the account. If you grasp these two concepts, then understanding the Roth IRA is easy.
Because you already paid taxes on your contributions, you can withdraw them at any time — even before age 59 1/2 — without paying taxes or penalties. But, all money above and beyond the contributions are fully taxable and subject to penalties.
So, if you put $5,000 into an IRA for 10 years, that is $50,000 in contributions. If during that time, your investments have done well such that the total value of the account is $110,000, then, you could withdraw up to $50,000 with no taxes or penalties. However, money withdrawn after that would be subject to taxes and penalties unless you are over age 59 1/2 unless you meet one of the following exceptions:
- Disability (as defined by the IRS)
- Certain qualified first-time home buyer distributions
- Certain medical insurance premiums while unemployed
- Certain unreimbursed medical expenses above a percentage of income
- Due to certain IRS levies
- Qualified reservist distributions
- Distributions as part of a series of substantially equal period payments for life (This is a neat exception for some people. I’ll have to cover it in detail elsewhere, but you can start taking money whenever you want if you essentially calculate an annuity amount and take the calculated amount every year.)
- Distributions for certain higher education expenses.
Note the above exceptions are still taxable, but are not subject to the 10% penalty. In other words, if you took $10,000 out of your Roth IRA to pay tuition, that $10,000 still counts as income (and is taxes as such) but there is no $1,000 (10%) penalty. Of course, the whole amount is tax and penalty free if it was part of your contributions to the account.
How a Roth IRA Works
Functionally, a Roth IRA works just like a regular IRA. You open an account with an IRA custodian, typically a bank or brokerage, and deposit money into the account. Within the account, you can invest in stocks, bonds, mutual funds, and other investments. Those investments pay dividends, have capital gains, and the like. Since the Roth IRA is a tax-advantaged account, you do not pay taxes on those dividends or capital gains, or anything else, so long as it is in the account.
Every year, you will get a Form 5498 from your IRA custodian. Since a Roth IRA does not give you a tax deduction, you really don’t do anything with the Form 5498, other than stick it in your folder of tax documents. (The purpose of the form is to let the IRS know about the contribution. You are just getting a copy.)
When it comes time to make a withdrawal, you follow your bank or brokerage’s procedure. It may be as simple as filling out a form, or even doing an online transfer. When you start making withdrawals, you will get a Form 1099-R from your custodian. It will report the amount of the distribution, but that distribution will not be taxable, unless you are under 59 1/2.
Using Roth IRAs for Other Stuff
A lot of the difficulty understanding Roth IRAs comes from the fact that you can use them for other stuff by withdrawing your contributions, even if that isn’t necessarily the best idea.
Consider, for example, you want to save money for a vacation home. As your second home, you can’t use the first-time homebuyer exception, but you could use your contributions.
It would work something like this:
- Every year, you and your spouse contribute $5,000 into a Roth IRA, or $10,000 total.
- After 5 years, you have $50,000 in contributions, and some amount of earnings. Let’s say you have $10,000 in earnings, or $60,000 total account balance.
- You withdraw $50,000 for the down payment, and leave the remaining $10,000 in the Roth IRA to grow for retirement.
This isn’t necessarily the best move. After all, you’ve just raided your retirement account. Theoretically, if you had plenty of money elsewhere for retirement, say a pension, or you’ve contributed a ton to a 401k account, then maybe this makes sense. However, if you aren’t already feeling pretty solid for retirement, this kind of thing is only setting you back.