What is a Roth IRA?

  • Bhumika Dutta
  • Aug 08, 2021
  • Financial Analytics
What is a Roth IRA? title banner

Introduction

 

We as individuals are often required to plan about our financial situations. Be it people working in 9 to 5 jobs or entrepreneurs and business enthusiasts, it is essential for all to think about their financial planning, especially after retirement. This is where IRAs play a huge role. IRAs or Individual Retirement Accounts are tax-advantaged accounts that can be used by individuals to save and invest for their retirement. 

 

Individual retirement arrangements (also known as IRAs) are used by the Internal Revenue Service (IRS) to refer to individual retirement accounts, individual retirement annuities, and other trusts and custodial accounts that serve as personal savings plans with tax advantages for putting money aside for retirement.

 

There are a few types of IRAs including traditional IRAs, SEP IRAs, SIMPLE IRAs, and Roth IRAs. In this article, we are going to discuss Roth IRAs and their advantages and disadvantages, qualifications and opening of a Roth IRA with withdrawals and distributions.

 

(Recommended read: What is a Hedge Fund?)


 

What is a Roth IRA?

 

Roth IRA was established in 1997 and was named after former Delaware Senator, William Roth. A Roth IRA qualifies for tax-free withdrawals when certain requirements are satisfied. They are supported using post-tax money, and donations are not tax-deductible. However, once the money is withdrawn, these become tax-free. 

 

Roth IRAs are different from traditional IRAs as in traditional IRAs, the deposits are done with pre-tax money and hence, one gets tax deduction on the contribution as well as the pay income tax when they withdraw the money during retirement. So, if someone wants an immediate tax break, they can opt for traditional IRAs. But Roth IRAs are better for a tax-free income in retirement. 

 

(Also read: 6 Fintech Products in India)

 

Roth IRAs, like other retirement plans, grow the invested money tax-free but it is better than others as it is way less restrictive in various ways. The first is that the contributors can be of any age and can make contributions as long as the account holder has earned income. There are also no required minimum distributions (RMDs) in Roth IRAs, so the user can maintain them indefinitely. 

 

Regular contributions in Roth IRAs can be made only with cash or checks. Stocks or assets are not liable as a mode of payment. However, after funds are donated, a Roth IRA offers a wide range of investment alternatives, including mutual funds, equities, bonds, ETFs, CDs, and money market funds.

 

According to Investopedia, the fund sources of a Roth IRA can be:

 

  • Regular contributions

  • Spousal IRA contributions

  • Transfers

  • Rollover contributions

  • Conversions

 

How to open and contribute to a Roth IRA?

 

An IRS approves institutions like any bank, brokerage company, federally insured credit unions, and saving and loan associations. A Roth IRA must be established with such an institution. It can be opened at any time but contributions for a tax year must be made before the tax-filing date of the IRA owner. The money can be added over time through smaller contributions or lump sum amounts. 

 

On the establishment of the IRA, the owner is required to submit the IRA disclosure statement and the IRA adoption agreement and plan document. These explain the rules and restrictions that must be followed by the Roth IRA and form an agreement between the IRA owner and the IRA trustee.

 

Every institute offers a different fee structure for the Roth IRAs. This results in different investment returns according to the fees. The risk tolerance of the account holder and the investment preferences also matter while opening the account. 

 

Some providers charge an inactivity fee if the account has been inactive for a certain period of time, some suppliers provide a broader range of stocks or exchange-traded funds than others, while the others might charge a higher minimum account balance. This all depends upon the type of investment the user is interested in. 

 

(Interesting to read: Mutual funds in India)

 

To contribute to a Roth IRA, the IRS limits the amount of money and the sort of money that one might want to deposit. Wages, salaries, incentives, bonuses, and other payments provided to the employee for the services they perform are all eligible to finance a Roth IRA for individuals working for a company. 

 

Money from a divorce, such as alimony, child support, or a settlement, can also be given. Anyone with taxable income can contribute to a Roth IRA, as long as they fulfill specific filing status and modified adjusted gross income requirements (MAGI).

 

According to this source, the following are the eligibility criteria for contributors in the year 2021:

Category

Income Range

Married and filing a joint tax return

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

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

Full: Less than $125,000

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

 

Withdrawals and Distributions of Roth IRA


 

In a Roth IRA, one can withdraw their original contribution according to their own choice of time, without having to pay any taxes or penalties. While withdrawing, the IRS assumes that the original contributions of the account holder are brought out first. Eligible distributions from the account's investment profits are tax-free. 

However, if one chooses to withdraw early or otherwise does not fulfill the requirements for a qualified withdrawal, the IRS may demand a piece of those returns in the form of taxes and a potential penalty. 

 

People who are at least 59 ½ years old and have held their accounts for at least five years are eligible to receive distributions, including earnings, without paying federal taxes.  If the user takes out the same sum as he/she puts in, there will be no tax involved, regardless of age. This is known as a qualified distribution. 

 

(Related reading: What is Personal Finance?)

 

To be eligible, a distribution of account profits must occur at least five years after the Roth IRA owner created and financed his/her first Roth IRA, and it must happen under at least one of the following conditions:

 

  • When the payout happens, the Roth IRA bearer must be at least 59 ½ years old.

  • The distributed assets are used to purchase the first home for the Roth IRA holder or a qualified family member. This is restricted to $10,000 per person, per lifetime.

  • After the Roth IRA holder becomes handicapped, the distribution happens.

  • Following the death of the Roth IRA holder, the assets are transferred to the Roth IRA holder's beneficiary.

 

(Also read: What are RBI Bonds and its features/details?)

 

Advantages and Disadvantages of Roth IRA:

 

According to nerd wallet, the advantages of Roth IRAs are as follows:

 

  1. Roth IRAs can save the user from potential tax savings. If there are chances of higher tax rates in the future, then it is better to opt for Roth IRAs as the account holder will have to pay for taxes when the tax rate is lower, rather than in the future when tax rates have risen.

  2. It is easier to withdraw money through Roth IRAs anytime without paying any extra tax or penalty.

  3. One can contribute to a Roth IRA in addition to a 401(k).

  4. The Roth IRAs also provide flexible timing, that is one can contribute to a Roth IRA according to their choice.

  5. One can contribute till the tax deadline of the year. So there’s extra time to contribute. 

  6. Once a user reaches 59 and half years of age and has maintained the account for at least five years, he or she can withdraw distributions from a Roth IRA, including profits, without incurring federal income taxes.

  7. There is no age limit to open a Roth IRA, as long as one has earned income.

  8. Roth IRAs are exempt from the required minimum distributions required from a conventional IRA or 401(k) beginning at the age of 72.

 

Like advantages, Roth IRAs also have some demerits that are worth mentioning:

 

  1. Roth IRAs do not allow the account holder to take any loans as other IRAs do.

  2. If someone wants to withdraw their amount before the age of 59 and ½ years, they will need to pay a 10% penalty. 

 

(SImilar read: Introduction to Insurance Regulatory and Development Authority (IRDA))

 

 

Conclusion

 

There are many IRAs in the market but as compared to traditional IRAs, Roth IRAs are better as they work as a smart saving tool for young people who are just starting out. Money saved in accounts like 401(k)s and traditional IRAs results in tax obligations in retirement. A Roth IRA might be a simple method to manage that tax bill.

Comments