A Roth IRA is different from both a traditional 401(k) and traditional IRA in some pretty important ways.
401(k)s and IRAs are types of savings accounts that allow you to invest in stocks, bonds, mutual funds, certificates of deposit, ETFs and index funds, among other investments, using your pre-tax dollars. Your earnings and interest also grow without having to pay taxes on the income until you retire.
The Roth IRA is different from other retirement plans. Here’s an explainer:
What is a Roth IRA?
A Roth is a type of IRA. As opposed to a traditional IRA, which is funded with pretax dollars, it’s funded with after-tax dollars. Like a traditional IRA, however, once you’ve funded the account, your earnings grow tax free.
Why is the different tax treatment important?
When you fund a traditional IRA using pre-tax dollars, you’re lowering your tax rate. Say you make $50,000 a year and you’re under the age of 50. You can put up to $5,500 away each year, which lowers your taxable income to $44,500.
Not only do you save on your tax bill, the money you put away grows without Uncle Sam taking a piece until you retire. And that can really add up.
Your Roth IRA is funded with your after-tax take home pay. You don’t get the upfront tax benefit like a traditional IRA, but your earnings will also grow tax free.
So why not just stick with a traditional IRA?
Here’s the key difference. Once you reach full retirement age, defined by the Internal Revenue Service (IRS) as age 70 ½, you’re required to start taking money out of your traditional retirement accounts. These distributions are taxed as regular income.
(It’s called a required minimum distribution, and it’s based on a somewhat complicated formula we won’t bother you with now.)
There are no required distributions with a Roth. If you’ve followed all the rules, you can take out cash without without paying taxes.
I still don’t get it, why does that matter?
Most of us will want to maximize income in our retirement years, when we’re likely to have stopped working completely or scaled back on it. Even our social security income will be subject to taxes. Having access to cash from a Roth that you don’t have to pay taxes on can come in extremely handy.
Does a Roth IRA offer other potential benefits?
If you’re under the age 59 1/2, after five years, you can withdraw up to $10,000 for the purchase of a first home without paying any taxes or other financial penalties. Similarly, you can make withdrawals for qualified educational expenses, and for medical and health insurance costs if you’re unemployed.
As opposed to a traditional IRA, where you must stop making contributions by age 70 ½, you can also contribute to a Roth IRA until the day you die.
Are there any restrictions on setting up a Roth IRA?
Yes. If you earn $132,000 or more annually and are a single taxpayer, or are married and filing separately, you can’t contribute to a Roth. Similarly, if you’re married and filing taxes jointly with your spouse, and your combined income is $194,000 or more, you also can’t set up a Roth.
Can I have a Roth and a traditional IRA at the same time?
Yes. But under age 50, you’re restricted to a total annual contribution of $5,500 to one or across both accounts. (At age 50 and over, you contribute up to $6,500.)
Are there penalties I should be aware of?
Yes. While contributions within a Roth IRA can be withdrawn at any time, since you’ve already paid taxes on them, you may be subject to penalties and taxes on earnings withdrawn prior to age 59 ½, and for accounts open for less than five years.
So why it is called a Roth?
It’s named after Sen. William Roth, who died in 2003. He helped sponsored the legislation that created these accounts in 1998.
- A Roth IRA is a great tool in your retirement planning arsenal.
- Your investments will grow tax-free.
- A Roth IRA can help provide you with important tax-free income in your retirement years.
As a final note, it’s always best to consult with a tax advisor or accountant for any questions you have about IRAs or 401(k)s.
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Jeremy Quittner is the financial writer for Stash.