Sunday, 20 October 2019

How Does a Roth IRA Work?

How Does a Roth IRA Work?
20 Dec
9:32

As you plan your retirement for life after work, you’ll face a multitude of choices. You might have a 401(k) through your job, for example, and if it matches contributions, you should take advantage of it. But if you don’t have that option or you want some extra security, you could open an individual retirement account (IRA).

There are a few different types of IRAs, but the two most popular ones are the Traditional IRA and the Roth IRA. The right choice for you depends on many different factors. Here’s the difference between the two popular IRAs and how Roth IRAs can work for you.

How does a Roth IRA work?

Roth IRAs are taxed now, not later

The main differentiator between Roth IRAs and Traditional IRAs is how they’re taxed. When you contribute to a Traditional IRA, all your money goes in tax-free. When you make contributions into a Roth IRA, that money is taxed now.

A Traditional IRA is a great option for those who want all their dollars to go toward investing as soon as possible. With Roth IRAs, you have to envision how your finances will look when you retire. Having taxes taken out now means they won’t be taken out again when you eventually make withdrawals. If you’re expecting to earn more money by the time you retire, avoiding the tax penalties later on in life can mean significant savings.

Withdrawals from Roth IRAs are penalty-free

Although putting money into a Roth IRA is taxed, you can take money out tax-free. For Traditional IRA accounts, you get taxed on withdrawals when you’re eligible to make them—which isn’t a problem if you’re earning less money later on in life. If however, you’re hoping to earn more than you did at the beginning of your career, it might make more sense to stick with a Roth IRA.

Having the luxury to withdraw money without getting taxed means more money in your pocket in retirement. If you don’t plan on working in retirement, you’re going to need every dollar you’ve invested

No limit on contributions based on age

For some people, the older you get, the younger you feel. So if you’re getting older and you’re not interested in retiring anytime soon, you may still be interested in contributing to your IRA. If you’re older than 70 and a half and you have a Traditional IRA, you can’t make contributions because there’s a stopping point.

On the other hand, Roth IRA account holders can continue to make contributions—and withdrawals— as long as they’d like. Keep in mind that you may be penalized if it’s before you turn 59 and a half years old. This applies to both Traditional and Roth IRAs; however, Traditional IRAs force you to start making withdrawals at 70 and a half — even if you don’t want to.

Eligibility might hold you back

If you’re thinking about a Roth IRA, you might want to check your eligibility first. If you make more than $137,000 as a single filer or more than $203,000 filing jointly (2019), you won’t qualify for a Roth IRA. If that’s the case, a Traditional IRA might work best for you. If, however, you’re below the threshold and want to get every dollar you can out of retirement, a Roth IRA might be the route to take.

Converting Traditional IRAs to Roth IRAs

You can convert to a Roth IRA if you don’t meet the income requirements or if you held a Traditional IRA at some point in your life. Once you make this change, however, you can’t go back to a Traditional IRA — permanently solidifying its status as a Roth IRA.

Converting a Traditional IRA into a Roth IRA is sometimes called a “backdoor Roth,” which is starting with one type of IRA and moving to the other. Keep in mind that you’ll owe taxes on any pre-tax IRA contributions. Once you make the change, you can’t take out any money penalty-free until at least five years after you’ve converted your account.

Opening a Roth IRA

Now that you know how Roth IRAs work, you may be ready to open one. You can go with an online brokerage account, which will help you manage your investments. Look for an account that has low fees and minimal opening balances. If you prefer more of a hands-off approach, consider a robo-advisor to help with your investing decisions.

Opening an account is only the first step. You’ll need to continue making regular contributions to ensure your investments are growing a consistent, steady pace. Whether you contribute every paycheck, month or year, adding money to your Roth IRA should always be included in your budget.

How does a Roth IRA work into your financial goals?

If you’ve decided that a Roth IRA is best for your investments, make sure you choose an investment company wisely. You can go with an online brokerage — where you choose your investments yourself — or a robo-advisor that does it on your behalf. Just remember that you have options, and should always work towards increasing your wealth for as long as you’re able to make regular contributions. You’ll be thanking yourself later — during retirement.

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Dori Zinn |

Dori Zinn is a writer at MagnifyMoney. You can email Dori here

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