Individual retirement account funded with after-tax dollars
What is a Roth IRA?
A Roth IRA is a tax-advantaged investment account available to individual taxpayers. This type of investment account allows investors to “shelter” a portion of their income from future taxes and enjoy larger investment gains.
The idea behind the government-created tax sheltering vehicle is to encourage greater financial independence and stability among American retirees, i.e. not to rely solely on a company pension, 401k, or social security.
A key attribute of a Roth IRA is that taxes on income are paid upfront by the investor and, in exchange, the gains in the account are free from taxes when withdrawn. Additionally, Roth IRAs do not come attached with required distributions when you reach retirement meaning if you don’t need the money, you can allow it to continue to grow tax-free.
The catch with the Roth IRA account is that withdrawing money is difficult and expensive. While an investor can withdrawal the amount they contributed to the account, they cannot withdrawal the investment gains without significant penalties. So, in this sense, money in Roth IRAs is “locked-up” until retirement.
Typically, younger individuals will benefit the most from a Roth IRA account as they are likely to pay lower income taxes and have a longer timeframe to accrue gains on their investments.
Key Points
- A Roth IRA is a special type of investment account, not an investment in and of itself.
- Taxes on deposits are paid upfront and gains are tax-free.
- Contributions are not locked in from withdrawals, but investment gains are.
- Roth IRAs do not have required minimum distributions meaning you don’t have to withdraw money if you don’t want to.
7 Roth IRA Traits and How they Work
Roth IRAs are individual retirement accounts aimed at helping people grow their wealth. Like any retirement account, they have their own traits that draw people to them. Here are the 7 defining traits of Roth IRAs.
1. Taxes on contributions to a Roth IRA are taxed upfront but not later, i.e. no tax-deferral.
Where the Roth IRA gets most of its notoriety from is the tax advantage it provides investors on their withdrawals. Since investors pay taxes initially, they are free from any additional tax obligations including capital gains in the future.
There are at least two possible advantages to this. First, for a young person who expects their earnings to increase, (i.e., taxes increase) contributing now and paying taxes upfront effectively locks in a lower tax cost on their invested dollars. Second, even without changing tax rates, the investor still can grow their money free from additional taxes such as capital gains.
2. Roth IRAs can be held indefinitely since there is no required minimum distribution.
Not paying taxes later comes with an added benefit, no required minimum distributions. Since the government has already received their tax dollars they don’t force you to make withdrawals like you would need to with a traditional IRA.
This means if your money is in a Roth IRA you can continue to hold it in a Roth for as long as you like including using it to pass on your investments tax-free to your heirs.
3. Roth’s are investment accounts, not an investment themselves. Meaning an investor can invest in almost any investment they wish through a Roth IRA account, such as individual stocks, mutual funds, ETFs, bonds, etc.
When you have a normal brokerage account, you’re free to choose whatever investment you would like to hold in the account. The same is true for a Roth IRA but with the Roth, you have the added benefit of tax sheltering that you don’t with a normal brokerage account.
Unlike with most employer-sponsored retirement plans, such as 401Ks, where investment selections are often narrowed down to a predefined selection of mutual funds. With a Roth IRA, you are free to invest in pretty much any security you wish. This is a big advantage for investors who wish to dedicate time, energy, and education to find investments that may yield better than average returns. *These investments do exist but are not guaranteed and often require extensive time, knowledge, and effort to identify.
4. Once the money is in a Roth IRA it is often difficult to withdrawal before retirement.
There’s a reason it’s called a retirement account – it’s for retirement. Since the government is passing on a tax shelter to help people establish their retirement the government wants to discourage early withdrawals outside of retirement.
The way this works with a Roth IRA is that you may withdraw the after-tax contributions you have made at any time, but you cannot withdrawal investment gains without incurring a significant penalty.
5. Withdrawals can be made penalty-free starting at age 59 ½ on accounts that have been held for at least 5 years.
So, when can you finally access your money free and clear? If you’ve held the Roth IRA account for at least 5 years and are age 59 ½ then you can start making withdrawals free from penalty.
There are some additional scenarios where withdrawals can be made penalty-free such as a first-time home purchase, paying qualified education expenses, and so on.
6. Annual contributions are limited to $6,000 (for individual) or $12,000 (for married) and are off limits if your income is over $140,000 (individual) or $208,000 (married).
Unfortunately, like all good things, there are limits to how much you can contribute to a Roth IRA. In 2021, the maximum annual contribution amount for an individual is $6,000 unless you’re over 50 in which case the contribution amount is raised to $7,000.
7. Contributions are allowed to be made to a Roth IRA at any age.
So long as you have earned income, i.e. income such as W-2, and are within the income limits you can contribute to a Roth at any age.
Sometimes individual taxpayers who still want to contribute to a Roth IRA but are outside of the income limits may contribute to a traditional IRA then convert the traditional IRA to a Roth IRA which is allowed. However, at the time of conversion, you will be liable for taxes on the traditional IRA account.
Math Behind a Roth IRA vs No Tax-Advantaged Account
So how does the math work out with a Roth IRA? What impact does the tax advantage make? The short answer is, pretty significant. To make this point we can look at an example comparison between a Roth and a traditional brokerage account without tax benefits.
Roth IRA
Let’s say we’re less than 35 years old and in the 24% tax bracket. In our scenario, we’re all about opening and contributing to a Roth IRA. In our first year of owning our Roth IRA, we decide to dedicate $6,000 of our income to the account.
To keep it simple, let’s say this is the only contribution we ever make to our Roth IRA, here’s how the math would work out.
Since we’re contributing $6,000 to a Roth IRA we must pay income taxes on this. Being in the 24% tax bracket the after-tax amount we contribute would be $4,560*. If we allow our investment to grow for say 40 years (puts us in retirement) and we invest in stocks/mutual funds returning a realistic 10% average our Roth IRA would end up being worth ~$206,382.
With our investments in a Roth IRA, the $206,382 value of our account is free from any taxes at this point so that $206,382 is ours to keep.
Not too bad but how does this compare to a normal, not tax-advantaged brokerage account?
*This example is extremely simplified to illustrate the concept. For example, taxes are graduated meaning your effective income tax is likely going to be lower than 24% if you’re in that tax bracket.
Normal Brokerage Account
If we keep all the conditions from the scenario above but change our account type to a normal brokerage account -no tax advantages attached- how would the math change?
In the case we use a normal brokerage account dedicating $6,000 of our income towards the investment account, we would still only have $4,560* to invest after we pay taxes. If we were to invest in the same stocks/mutual funds we did above and earned the same realistic 10% annual average for 40 years our account would grow to ~$206,382.
So how is this any different? Since, in this scenario, we’re using a normal brokerage account we still have to pay capital gains on our investment gains. Subtracting our initial investment from our ending investment our gain is ~$201,822. This is the amount we will likely have to pay capital gains tax, most likely 15%. Applying the tax, we end up receiving $181,640 and pay the government $20,182 from our account.
*This example is extremely simplified to illustrate the concept. In addition to the tax consideration from above, we omitted the effect of capital gains on trading costs for portfolio repositioning.
Conclusion
In either case, when keeping everything equal, you would have saved a meaningful amount towards your retirement.
So, which is better? Generally, a Roth, however, it depends. What really decides which is better is answering “do I need this money and its possible gains before retirement?”, “are there investments I want to make that cannot be made within a Roth?”, “are there better investments that cannot be made within a Roth?”
Eligibility and Limits
Roth IRA Contribution Limits 2021
| FILING STATUS | 2021 INCOME (MAGI) | CONTRIBUTION |
|---|---|---|
| Single/Head of Household | $125,000 or less | 100% to Limit |
| Single/Head of Household | $125,000 to $140,000 | Partial Contribution |
| Single/Head of Household | Above $140,000 | Direct Contribution not Allowed |
| Married Filing Jointly | $198,000 or less | 100% to Limit |
| Married Filing Jointly | $198,000 to $208,000 | Partial Contribution |
| Married Filing Jointly | Above $208,000 | Direct Contribution not Allowed |
Benefits and Drawbacks of Roth IRAs
Roth IRA Benefits
- No required minimum distributions
- Shelter from capital gains tax
- Investment account is open to almost any investment
- Gains on invested money is not easily withdrawn
Roth IRA Drawbacks
- Taxes must be paid upfront
- Gains on invested money is not easily withdrawn
- Limited contribution amount
- Some investments cannot be used within IRA
Setting Up a Roth IRA
Setting up a Roth IRA account can be super simple as many online brokerages offer these accounts. If your taxes are simple these accounts can be useful. However, if your taxes are more complex it may be beneficial to seek the assistance of a qualified professional.
Assistance could come from a financial advisor who will likely be able to help set up and manage the account as well or from a tax accountant.
*Lottie animation is from lottiefiles.com and was created by KC Woon
