What to Know When Starting a Roth

There are still six more months to make your 2018 Roth IRA contributions.

Roth IRAs are simply a type of investment account for retirement planning. Importantly, they are not a type of investment. Just like you can put nickels, dimes, dollar bills or checks from grandma in a piggy bank, you can hold a variety of different investments—mutual funds, stocks, bonds, CDs, etc.—in your Roth IRA.

Why Open a Roth IRA?

What sets Roth IRAs apart is special tax treatment. Your investments grow tax-free, and you can withdraw your money tax-free when you retire.

So, for the sake of simplicity, let’s say that you contribute $1,000 of after-tax income a year to your Roth IRA. And let’s say this $1,000 each year is invested in an S&P 500 index fund. If you do this from age 25 to 65, at an average annual return of 10 percent, you will end up with $527,000. Now, remember, you contributed a total of $40,000 to your fund (40 years at $1,000 per year), so your investment grew $487,000. That whole $487,000 is tax-free.

If, on the other hand, you’d simply invested that $1,000 in a normal mutual fund—where your earnings did not grow tax-free and the capital gains rate remained at 20 percent—you would have a mere $291,000. So, you can see that the Roth IRA tax advantages (tax-free growth and distributions), save you almost $200,000 in our hypothetical scenario. Not bad. Not bad, at all.

In addition to the tax advantages, if you need to access your money before age 59½, you can withdraw your contributions (not to be confused with earnings!) without penalty. Of course, you probably don’t want to tap into your retirement money early, but the option is there if you need it.

But Are You Even Eligible, Though?

To be eligible to open or contribute funds to a Roth IRA, you have to have taxable income that falls at or below the limit determined by your tax filing status. See the table below for 2018 Roth IRA income and contribution limits. (Note that you have six more months—until April 15, 2019, the tax filing deadline—to make a 2018 contribution.)

Filing Status Modified Adjusted Gross Income (MAGI) per IRS: Annual Contribution Limit:
Married filing jointly Less than $189,000 $5,500 (Unless you’re 50+, in which case you can contribute up to $6,500/year.)
$189,000 to $198,999 Less than $5,500; Calculate
$199,000 or more Ineligible
Married filing separately (If you haven’t lived with your spouse in the past year, you can use the limits for single people, instead.) $0 $5,500 (Unless you’re 50+, in which case you can contribute up to $6,500/year.)
$1 to $9,999 Less than $5,500; Calculate
Greater than $10,000 Ineligible
Single Less than $120,000 $5,500 (Unless you’re 50+, in which case you can contribute up to $6,500/year.)
$120,000 to $134,999 Less than $5,500; Calculate
$135,000 or more Ineligible

If you earn more than the limits described above, a backdoor Roth IRA might be worth considering.

A Word on Roth IRA Distributions

If you want to withdraw funds from your Roth IRA without paying penalty fees and taxes, then you have to make sure that you’re making a qualified withdrawal. In order for a withdrawal to be qualified, it must take place at least five years after you open your account, and:

  • You must be at least 59½ years old.
  • You’re making a qualified first-time home purchase for yourself, a child or a grandchild; up to $10,000 lifetime maximum withdrawal.
  • The funds are for higher education expenses for yourself, your spouse, a child, grandchildren or great-grandchildren.
  • Death or disability occurs.

If you don’t meet the requirements for a qualified withdrawal, you’ll have to pay income tax on your earnings plus a 10 percent early withdrawal penalty—which can add up to many more dollars than you might expect. Avoid unqualified withdrawals if at all possible.

Less Taxes Means More Retirement Money!

The tax benefits of a Roth IRA can potentially save you hundreds of thousands of dollars that would have otherwise gone to the tax man. If you’re eligible to invest, then it’s definitely worth looking into opening a Roth IRA. You’ve still got six more months before the 2018 deadline, so get going!