You may have heard of a Roth IRA, but what exactly is it? And how does it differ from a regular IRA?
We sat down with David Blaylock, a Certified Financial Planner™ with LearnVest Planning Services, to learn the ins and outs of the Roth IRA—and whether it's right for you.
What Is a Roth IRA?
IRA stands for “individual retirement account,” and it's a brokerage account that's specifically designated to fund your retirement. As with any brokerage investment account, it allows you to trade securities. But unlike other brokerage accounts, IRAs have tax benefits, and the difference between traditional IRAs and Roth IRAs comes down to those benefits.
"With a traditional IRA, your contributions are usually tax deductible, meaning that the amount you put into your IRA is exempted from your taxable income," Blaylock says. "But with a Roth IRA, you pay taxes on the money that you contribute before it enters the account."
So if you make $50,000 this year, and contribute the annual maximum of $5,500 to your traditional IRA, you’d only be taxed on $44,500 of your income and therefore pay less in taxes. Of course, this doesn't mean that you're completely off the hook for paying taxes on that $5,500—you'll have to pay them later, when you withdraw the money from your account 20 or 30 years down the road.
It sounds like no big deal, right? You either pay taxes now with a Roth IRA or pay taxes later with a traditional IRA. But, in fact, there's a huge difference because your IRA is a brokerage account and that money is growing as we speak. If you open a traditional IRA, and withdraw that money later, you'll be taxed on your contributions ... and your investment earnings.
Let’s say that you contribute $150 per month for 20 years, which comes out to $36,000. If you earn 7% returns, those contributions could morph into $78,000—over half of which would be your investment earnings. With a Roth IRA, you only pay taxes on that $36,000—and then you're done. With a traditional IRA, you’d be taxed on the entire $78,000 sum when you withdraw.
How Is an IRA Different From a 401(k)?
There is a third very common type of retirement account, although it doesn't have "IRA" in the name: a 401(k). "A 401(k) is a retirement account that's usually set up through an employer, while IRAs are created and managed by an individual," Blaylock explains. Also, when compared to IRAs, 401(k)s tend to have limited investment options.
With a 401(k), some employers "match" your contributions to a certain point, so if you contribute, they'll contribute some (free!) money too. "And you can contribute to a Roth IRA and a 401(k)," Blaylock adds. "So if your employer doesn’t match your 401(k) contributions, you may want to think about whether you’d prefer to bypass the 401(k) and focus on maximizing your Roth IRA instead."
There's one other type of account to consider: Roth 401(k)s, which work the same way as Roth IRAs—they tax you upfront, sparing your future earnings from the taxman. Although Roth 401(k)s used to be pretty rare, they're growing in popularity. If your employer does offer this option, read our guide to Roth 401(k)s. If your employer doesn’t offer one, the only way to open a Roth 401(k) is if you’re self-employed.
RELATED: Should I Roll Over My 401(k)?
Important Rules for Roth IRAs
A Roth IRA, while generally considered advantageous, isn't right for everyone. If you're in one or more of the following situations, it may be a good option for you:
1. You Earn Less Than the Income Limit
As of 2013, you can contribute up to $5,500 to a Roth IRA ($6,500 if you’re 50 or older), and your eligibility for a Roth IRA starts phasing out when your income hits $112,000 as a single person, or $178,000 as a married couple.
“The Roth IRA makes sense for most people,” Blaylock says. For one, you’re only taxed on the contributions that you make today, rather than your potentially large future earnings. This is ideal for people who start saving for retirement in their twenties or thirties because they'll likely earn higher salaries as the years go by. And the higher your salary, the higher your tax bracket—so by locking in pre-retirement tax rates through a Roth IRA, you’ll usually save money.
However, “if someone makes a lot of money, and has few tax deductions, a Roth IRA might not make as much sense,” Blaylock adds. "Simply put, the level of tax deduction in a traditional IRA might be a real benefit if the individual doesn't have many other deductions—that person can take advantage of the deduction today, instead of waiting until retirement." Similarly, if you’re making a lot of money, but expect your income to be substantially lower when you retire, you might want to take your deduction now through a traditional IRA while your income bracket is higher.
If you make too much to contribute to a Roth IRA, there may be a loophole: There’s no income limit for contributing to a nondeductible traditional IRA and then converting it to a Roth. That said, make sure to consult a tax expert before you do this because the technique has been known to cause unexpected complications for people.
If you opt for this approach, Blaylock finds that it’s best to wait a while before doing the conversion. “The IRS is pretty much aware of what’s going on, and if you make a contribution to a regular IRA and immediately convert it to a Roth IRA, they’ll have an incentive to change the rule," he says. "In some cases, people doing this may be subject to penalties.”
If you can’t contribute to a Roth IRA, Blaylock says, take advantage of whatever tax-deferred options you do have, whether that's a traditional IRA, SEP IRA (an employer-based retirement plan that can also be established by the self-employed), or 401(k) through an employer. “If you’ve maxed out all of these other options and want to save more for retirement, you can always open a nondeductible IRA,” he adds, referring to savings accounts for retirement that receive no tax deductions but grow tax deferred until you take the money out.
2. You Want to Leave a Legacy
A Roth IRA is also great if you want to pass this money onto future generations. “A traditional IRA has a required minimum distribution at age 70.5, at which point the government forces you to start taking out your money,” says Blaylock. “The Roth IRA, however, has no required minimum distribution, so the full amount could be transferred or inherited by the next generation.”
3. You Have Many Years Until You Hit Retirement Age
The main benefit of a Roth IRA is the fact that it excludes your investment earnings from a potentially higher tax rate in the future ... but if the future is only a few years away, you may not have that much in earnings or you're in a much higher tax bracket. “If, for example, you’re 55 and planning to retire at 60, that’s only five years of growth,” Blaylock says. “It may be in your best interest to just take that tax deduction from a traditional IRA, as opposed to the Roth.”
“That’s not to say that a Roth IRA doesn’t make sense if you’re 55," adds Blaylock. "It might still make sense, but it would require a deeper analysis, depending on your intentions. Whereas if you’re 25, I’m basically going to say that you should invest in a Roth IRA."
LearnVest Planning Services is a registered investment adviser and subsidiary of LearnVest, Inc. that provides financial plans for its clients. Information shown is for illustrative purposes only and is not intended as investment, legal or tax planning advice. Please consult a financial adviser, attorney or tax specialist for advice specific to your financial situation. LearnVest Planning Services and any third parties listed in this message are separate and unaffiliated and are not responsible for each other’s products, services or policies.