What is a 'Roth IRA'
Named for Delaware Senator William Roth and established by the Taxpayer Relief Act of 1997, a Roth IRA is an individual retirement plan (a type of qualified retirement plan) that bears many similarities to the traditional IRA. The biggest distinction between the two is how they’re taxed. Since traditional IRAs contributions are made with pretax dollars, you pay income tax when you withdraw the money from the account during retirement. Conversely, Roth IRAs are funded with after-tax dollars; the contributions are not tax deductible (although you may be able to take a tax credit of 10 to 50% of the contribution), depending on your income and life situation). But when you start withdrawing funds, these qualified distributions are tax free.
BREAKING DOWN 'Roth IRA'
Similar to other individual retirement plan accounts, the money invested within the Roth IRA grows tax free. Other defining characteristics of a Roth:
- Contributions can continue to be made once the taxpayer is past the age of 70½, as long as he or she has earned income.
- The taxpayer can maintain the Roth IRA indefinitely; there is no required minimum distribution (RMD).
- Eligibility for a Roth account depends on income.
Establishing a Roth IRA
A Roth IRA must be established with an institution that has received IRS approval to offer IRAs. These include banks, brokerage companies, federally insured credit unions and savings & loan associations.
A Roth IRA can be established at any time. However, contributions for a tax year must be made by the IRA owner’s tax-filing deadline, which is generally April 15 of the following year. Tax-filing extensions do not apply.
There are two basic documents that must be provided to the IRA owner when an IRA is established:
These provide an explanation of the rules and regulations under which the Roth IRA must operate, and establish an agreement between the IRA owner and the IRA custodians/trustee.
IRAs fall under a different insurance category than conventional deposit accounts. Therefore, coverage for IRA accounts is less. The Federal Deposit Insurance Corporation (FDIC) still offers insurance protection up to $250,000 for traditional or Roth IRA accounts, but account balances are combined rather than viewed individually. For example, if the same banking customer has a certificate of deposit held within a traditional IRA with a value of $200,000 and a Roth IRA held in a savings account with a value of $100,000 at the same institution, the account holder has $50,000 of vulnerable assets without FDIC coverage.
Not all financial institutions are created equal. Some IRA providers have an expansive list of investment options, while others are more restrictive. Almost every institution has a different fee structure for your Roth IRA, which can have a significant impact on your investment returns.
Your risk tolerance and investment preferences are going to play a role in choosing a Roth IRA provider. If you plan on being an active investor and making lots of trades, you want to find a provider that has lower trading costs. Certain providers even charge you an account inactivity fee if you leave your investments alone for too long. Some providers have more diverse stock or exchange-traded fund offerings than others; it all depends on the type of investments you want in your account.
Pay attention to the specific account requirements as well. Some providers have higher minimum account balances than others. If you plan on banking with the same institution, see if your Roth IRA account comes with additional banking products.
For individuals working for an employer, compensation that is eligible to fund a Roth IRA includes wages, salaries, commissions, bonuses and other amounts paid to the individual for services the individual performs for an employer. At a high level, eligible compensation is any amount shown in Box 1 of the individual's Form W-2.
For a self-employed individual or a partner in a partnership, compensation is the individual’s net earnings from his or her business, less any deduction allowed for contributions made to retirement plans on the individual’s behalf, and further reduced by 50% of the individual’s self-employment taxes.
Other compensation eligible for the purposes of making a regular contribution to a Roth IRA includes taxable amounts received by the individual as a result of a divorce decree.
The following sources of income are not eligible compensation for the purposes of making contributions to a Roth IRA:
- rental income or other profits from property maintenance
- interest and dividends
- other amounts generally excluded from taxable income
Contributing to a Roth IRA
In 2016, an individual may make an annual contribution of up to $5,500 to a Roth IRA.
Individuals who are age 50 and older by the end of the year for which the contribution applies can make additional catch-up contributions (up to $1,000 in 2016). For instance, an individual who is under age 50 may contribute up to $5,500 for tax year 2016, but an individual who reached age 50 by year-end 2016 may contribute up to $6,500.
All regular Roth IRA contributions must be made in cash (which includes checks); regular Roth IRA contributions cannot be made in the form of securities. However, a variety of investment options exist within a Roth IRA, once the funds are contributed, including mutual funds, stocks, bonds, ETFs, CDs and money market funds.
A Roth IRA can be funded from several sources:
- Regular contributions
- Spousal IRA contributions
- Rollover contributions
The Spousal Roth IRA
An individual may establish and fund a Roth IRA on behalf of his/her spouse who makes little or no income. Spousal Roth IRA contributions are subject to the same rules and limits as that of regular Roth IRA contributions. The spousal Roth IRA must be held separately from the Roth IRA of the individual making the contribution, as Roth IRAs cannot be held as joint accounts.
In order for an individual to be eligible to make a spousal Roth IRA contribution, the following requirements must be met:
- The couple must be married and file a joint tax return
- The individual making the spousal Roth IRA contribution must have eligible compensation
- The total contribution for both spouses must not exceed the taxable compensation reported on their joint tax return
- Contributions to one Roth IRA cannot exceed the contribution limits
Anyone who has taxable income can contribute to a Roth IRA – as long as he or she meets certain requirements concerning filing status and modified adjusted gross income (MAGI). Those whose annual income is above a certain amount, which the IRS adjusts periodically, become ineligible to contribute.
For 2016, the income maximums are:
- $194,000 for individuals who are married and file a joint tax return
- $10,000 for individuals who are married, lived with their spouses at anytime during the year and file a separate tax return
- $132,000 for individuals who file as single, head of household, or married filing separately and did not live with their spouses at any time during the year
Who Benefits the Most
Whether or not a Roth IRA is more beneficial than a traditional IRA depends on the tax bracket of the filer, the expected tax rate at retirement and personal preference. Individuals who expect to be in a higher tax bracket once they retire may find the Roth IRA more advantageous since the total tax avoided in retirement will be greater than the income tax paid on the contribution amount in the present. Therefore, younger and lower-income workers may benefit the most from the Roth IRA. Indeed, by beginning to save with an IRA early in life, investors make the most of the snowballing effect of compound interest: Your investment and its earnings are reinvested and generate more earnings, which are reinvested and so on.
As of the end of 2015, investors held $660 billion in Roth IRA accounts, roughly 9% of total IRA assets.