Roth IRAs are one of the best ways to save for retirement. This is not only because you will not be taxed on your investment returns over the years, and you can withdraw the money tax-free when you retire but also because initiating your account is an easy process.
Roth IRA’s have proven to be a great long-term savings vehicle, especially for younger workers, who are typically in the low tax bracket today, but will be in a higher tax bracket when they’re in their 60’s and 70’s, and at retirement age. Retirement-aged Americans who wish to bequeath assets to their heirs can also benefit by giving Roth IRA proceeds tax-free.
Your Roth IRA is a golden gift account from the IRS that protects your assets from taxes for decades to come. So, after contributing to the Roth IRA account, with after-tax dollars, the investments within the account grow and compound tax-free.
The icing on the Roth IRA cake is that you can withdraw the money in the account, tax-free if you’re over age 59 ½ and if the funds had remained in the account for at least five years. If that’s not enough, unlike a traditional IRA or 401(k) retirement account, you can pass the account on to your heirs without taking any required minimum distributions during your lifetime.
Roth IRA’s are gaining steam in the American retirement planning landscape. According to Investment Company Institute statistics, 24.9 million American households had a Roth IRA as at the year 2017.
Roth IRA’s are in the same individual retirement account family as traditional IRA’s, but they also have some unique differences. A Roth IRA’s allow account holders to contribute after-tax dollars to their retirement savings, then withdraw account dollars tax-free once they attain the age of retirement. There are no age restrictions when contributing to a Roth IRA, and you aren’t required to take out any required minimum distributions from your Roth IRA account. Roth IRA’s are a great idea if you believe you’ll rise to a higher tax bracket down the road – you’ll benefit by taking tax-free benefits from your retirement savings account in that scenario. On the downside, you may be subject to income limitations when opening a Roth IRA.
Setting up a Roth IRA is quite easy and is not complicated. All you have to do is demonstrate you have earned income from a job – either from an employer or if you’re self-employed. That makes you eligible for opening a Roth IRA account. Most people are eligible to start a Roth IRA. However, if you fall into the category of people who make more than $199,000 a year if you file jointly, or $135,000 if you file as a single person, you may not be eligible. By extension this will also imply that for married couples filing jointly, taxpayers must earn less than $189,000 to make a full Roth IRA contribution. You can also roll over funds from other retirement accounts into a Roth and pay taxes on the rollover amount.
To maximize your benefits, fill the account with investments which would typically be taxed at a high rate. Or alternatively, you can open your Roth IRA with a low-fee robo-advisor to get all the benefits without the hassle of managing the account yourself.
Benefits of ROTH IRA
- You get tax-free income in retirement: With Roth IRAs, savers get a tax-free stream of income in retirement. The only catch is that you pay income tax on your contributions upfront. Unlike the traditional IRA, which gives investors a tax deduction for the year the contribution is made, the Roth version lets savers contribute after-tax money today and withdraw principal and earnings tax-free at retirement. For individuals looking for tax diversification in retirement, the Roth IRA is one of the few buckets they can create that ensures that they have a stream of tax-free income on retirement.
- Roth IRAs offer flexibility: Setting up and maintaining an emergency savings account is like filling up a leaky bucket. It’s never going to be full, and if you don’t pay close attention, it will be empty very quickly. In a pinch, a Roth IRA could provide some quick cash. That’s because Roth contributions can be withdrawn penalty-free at any time. To take out more than just the contributions, investors must be at least 59 1/2 years old, and the account must have been opened for five years. But there are some qualified withdrawals if you don’t meet the age or holding period requirement.
- You can contribute after the age of seventy and half: with a normal IRA, investors must stop making contributions when they turn seventy and half years old, at which point they are forced to take distributions and begin paying taxes on that money. The Roth IRA has no required minimum distributions. This means that in theory, you can live to 120 without ever tapping your Roth IRA. In addition, anyone with earned income can keep adding to their Roth IRA account regardless of age.
- Your heirs benefit: The hands-off approach the IRS takes with Roth IRAs is beneficial for your heirs as well. Savers with ample accounts can leave their beneficiaries tax-free income that can be stretched over their lifetime. Grandchildren would receive tax-free income for the rest of their lives; all of the earnings for an extended period of time would be totally tax-free. The catch is that you pay taxes now on the contribution. But if you anticipate leaving money to kids or grand kids, forgoing the tax break today can give your bequest a boost in the future.
- High earners can still take advantage of a ROTH IRA: just like it was already stated previously, high-income earners cannot make a contribution to a Roth IRA. The IRS has income thresholds ($199,000 a year if you file jointly, or $135,000 if you file as a single person) that limit the size of the contribution that high earners can make. Above that threshold, direct contributions to a Roth IRA are not allowed. But there is a way around that. People who make a lot of money can make a nondeductible contribution to a traditional IRA and then convert it to a Roth.
You should however bear in mind that the IRS requires you to take into consideration all of your pretax holdings when figuring the tax liability of a conversion. Because it’s complicated, it’s best to consult a tax professional before attempting this maneuver.
6. Can be best long-term option: For people who are looking for relief from today’s tax bill, making a contribution to a traditional IRA offers a welcome tax deduction that you won’t get with a Roth.
But taking advantage of the tax break today leaves many of the valuable benefits of the Roth on the table. If you are eligible and have options, the Roth IRA over time is going to deliver a greater benefit in retirement. The ultimate benefit is in retirement because they are tax-free and can stay in the tax-free account even longer. In all the comparisons, putting money into the tax-free option will typically outweigh other options.
How to Invest in a Roth IRA
Your next step in the Roth IRA process is opening an account. Usually, it is advisable for people who are already making use of this plan to work with a reputable management firm. However, this is not compulsory as you can as well handle the process by yourself.
Here are the steps that are involved in setting up your own Roth 401k Plan:
- Figure out your contribution amount: The Internal Revenue Service (IRS) has established contribution limits of $5,500 annually for Roth IRA plan participants. However, Americans over the age of 50 are allowed a “catch up” hike in contributions, to $6,500. Annual deadlines for opening a Roth IRA account and making contributions is April 15 of the following tax year.
- Choose your investments: having determined whether you are eligible or not and our contribution limits and dates, you should start selecting investments to stock your Roth IRA. When making your investment selections, you should carefully review your long-term investment goals, and assess the amount of risk you will be willing to shoulder. Reviewing your retirement goals and needs can help choose the investment best suited for your own unique needs. By and large, there is a wealth of investment categories to choose from for your Roth IRA, including stocks, bonds, certificates of deposit (CDs), mutual funds, exchange-traded funds (ETFs), or a “single-fund” option, where the asset allocation is selected for plan participants. Additionally, real estate, commodities, and even foreign stocks and funds are eligible for inclusion in a Roth IRA.
- Choose a Roth IRA investment manager: There is no shortage of potential Roth IRA providers, including banks, mutual fund companies, brokerage firms, insurance companies, and online-only investment firms. When choosing a firm, ask about key issues that otherwise may be overlooked, like account management fees and demonstrated portfolio results.
- Organize your documentation: After you find an investment manager, make sure that everything is as it should be and that you have all of the necessary paperwork, which includes:
- Your driver’s license or another form of photo identification.
- Your Social Security number.
- Your bank’s routing number and your checking or savings account number.
- Your employer’s name and address, if you’re opening an account at work.
- The name, address, and Social Security number of your plan beneficiary.
How to Choose Your Investments
Making the decision to open a Roth IRA is just the first step toward a secure financial future. After you open an account, you will need to decide the assets you want it to hold. The questions you should ask yourself to help you arrive at the best investments choices include;
- Are you likely to do a lot of trading of individual stocks and bonds?
- Are you more of a buy-and-hold investor?
- Are you going to invest in mutual funds or exchange-traded funds?
- Do you only have a small amount of money to invest?
- Do you want help picking investments, or are you comfortable making your own decisions?
- Do you tend to use investment research to guide your decisions?
Depending on the answers to the questions above, you can put yourself in one or more of the following categories, each with their own rules for avoiding fees.
- Sophisticated, active investor: Go for an account with low per-trade fees. Some firms will even lower trading fees after a certain number per month, quarter or year, and will offer free access to proprietary research.
- Buy-and-holder: Avoid accounts with high inactivity fees.
- Mutual fund investor: You’ll want to pay particular attention to the fees charged by the individual funds that you invest in (these may be different than more general, administrative fees that your brokerage firm will charge for holding any type of retirement account). Mutual fund fees include account management, exchange, redemption and so-called 12b-1 fees. Account maintenance, management and 12b-1 fees are important regardless of whether you actively move in and out of different mutual funds. Mutual fund companies charge these fees to all investors to cover the cost of picking investments, marketing the fund, and general administration. You may pay exchange or redemption fees when you switch your money from one fund to another within the same fund company or when you sell your shares. These fees are most significant if you plan to move in and out of funds with some regularity.
- The hand-holder: if you fall in this category, then you will most likely require professional help in setting up and managing your retirement account, and as such you should be prepared to pay for it. The ideal is to find a good financial advisor who charges by the hour or a flat annual fee to manage your account. Those who get commissions based on your trading activity have an incentive to “churn” your assets; in other words, they get paid by how actively they invest, instead of how well they invest. Other firms charge an annual management fee, often one percent of the amount in the account. It’s only worth it if, over time, the manager’s returns exceed market averages by more than one percent. Otherwise, you may want to just invest in low-cost stock and bond index funds that mimic overall market performance—rather than trying to beat it.
Here are some types of investments to consider investing with your Roth IRA provider:
- Investments in the stock market
- Investments in the bond market
- Other income-generating investments
It goes without saying that the more risky an investment is, the more return it is likely to earn. That is why investments in stocks have historically paid higher returns. Bonds fall somewhere in between stocks and CDs.
Mutual funds in the marketplace are run by professional investors that spend all day long analyzing the holdings of their particular fund. They are in tune with the news and recent happenings pertaining to the industry and they are dedicated to making the fund money all the time. By stepping out of the mutual fund realm and selecting individual stocks and bonds to invest in you are taking an enormous risk. Granted, with great risk can come great reward. The stock you choose could double in the course of a week. On the other hand it could drop to 20% of its value, or your individual bond borrower may go bankrupt. Mutual funds are a much safer bet for a majority of investors that don’t have the time to constantly be researching individual stocks.
For Roth IRAs, most experts recommend buying two to six different mutual funds or exchange-traded funds, some that focus on stocks and some that have bonds. You should also keep a small portion of your account in cash or cash equivalents, such as money-market funds. Look for funds that have expense ratios of less than 0.5.
Another good option is target-date funds or lifecycle funds. These are designed to automatically diversify your investments and adjust over time, so that you have less risk of a large drop in value as you near retirement. Some examples of good fund families are Fidelity’s Freedom Funds or Vanguard’s Target Date Funds. If you buy a target date fund, remember it is designed to hold your entire retirement nest egg. It’s best to buy just one.
Tips That Can Help You Boost Your ROTH IRA Investments
- Be strategic about your Roth IRA investments: You can invest in all kinds of securities through your Roth IRA, but some make more sense than others. For instance, it’s not the best strategy to park municipal bonds in a Roth, because they’re typically already tax-exempt. Low-interest-rate CDs and slow-growing stocks are also not ideal.
So what type of invests should you go for? You should consider parking in it those stocks you expect to be your fastest growers, especially if you’re a long way to retirement. If a stock averages 15% growth per year for 25 years, a $5,000 initial investment in it will turn into about $165,000, with that $160,000 of gain being tax-free if you withdraw it in line with the rules.
Real estate investment trusts (REITs) are also good for Roth IRAs because they tend to generate a lot of dividend income, but much or all of that is often not eligible for the low long-term capital gains tax rate, and is instead taxed at your ordinary income-tax rate.
In a Roth, there can be no tax at all. You can also do quite well just investing in a broad-market index fund or two, or a target-date fund, in your Roth IRA. Such a simple approach can be very effective.
2. Max out your Roth IRA: you should make sure that you invest all you can in your Roth IRA each year. You’re limited as to how much you can contribute to an IRA, or to several of them. Contribution limits (for all your IRAs together, not for each of them) are adjusted over time to keep up with changes in the cost of living. The limits for both the 2015 and 2016 tax years are the same: $5,500. There’s also an extra $1,000 “catch-up” contribution permitted for those age 50 or older, letting those folks sock away as much as $6,500 for the year.
To get the most from your Roth IRA, fill it with as many dollars as possible. Granted, sending in $1,000 or even $3,000 to your IRA can help build a small fortune for retirement, but you can build a bigger and better one by maxing out your contributions. For instance, imagine that you contribute $4,500 every year for 25 years to an IRA, and it grows at 10% annually. That will grow to nearly $487,000; which is pretty good. However, if you choose to contribute $5,500 annually (just $1,000 more), and it all grows at 10% per year, the end result will be $595,000 – a difference of $108,000! Of course, as the annual contribution limits rise each year, you should aim to keep contributing more, ending up with an even large sum of money when you eventually want to withdraw it.
3. Don’t skip year: It’s easy to think that a single missed year won’t matter much, but if you made those $5,500 annual contributions for just 24 years instead of 25, you’d end up with $535,000 – about $60,000 less!
4. Be patient and stay the course: a large amount of wealth is generally accumulated over time. So as you contribute to your Roth IRA, don’t let fear or impatience derail your progress. If the market swoons, it’s easy to panic, as so many do, and perhaps contribute less to your IRA, or skip a year of contributions, or sell some stocks in your IRA that have fallen in value even though they’re likely to regain value. Read up and learn enough about investing so that you’re comfortable with the investments you’ve chosen, so that you know to expect occasional downturns in the market. The more you learn, the better choices you’ll likely make, and the more your money will likely grow.
5. Consider converting other savings into Roth IRAs: if you have money in a traditional, not Roth, IRA, look into whether it makes sense to convert that IRA into a Roth. Doing so means you’ll face a tax hit, as the money you’re converting has avoided taxes so far, but will be going into an account funded with post-tax money.
You’ll have to think about whether the tax hit is likely to be worth it. Conversions can make particular sense for younger people, whose Roth IRAs have very long growth periods ahead of them. They can also be smart to do so during a market crash or correction, as the sum you’re converting will be smaller.
If you’re strategic about moves you make with your Roth IRA, you can accumulate even more in it – and can set yourself up for tax-free withdrawals in retirement.
6. Take age and risk comfort into consideration in all you do:
- Age: As a general rule, the closer you are to retirement age, the less risk you want to assume. If you’re only a few years away from hanging up your day job, then you can’t afford a drastic downturn in your portfolio. Likewise, if you are many years from retirement and just starting out in your investing, then you can afford to accept some risk in your investments. Even a prolonged market slump, like the Great Recession that began in 2008, won’t kill your portfolio, because you have a couple of decades to recover those losses.
There are a multitude of methods to determine exactly how much of your portfolio should be in higher-risk investments such as stocks versus how much should be in safer investments like bonds. One popular method is the “120 minus your age” formula. You simply subtract your age from 120. The resulting difference represents the percentage of your portfolio that should be in equities. For example, if you’re 25 you should have 95% of your portfolio in stock investments. If you’re 60 and about to retire you need to scale your investments back to 60% stocks and 40% bonds (or other lower-risk assets).
- Comfort Factor: The second factor that determines where you should invest is how comfortable you are with risk. If the thought of putting money into the volatile stock market terrifies you then you’ll need to adjust your portfolio (and perhaps your expectations) accordingly. You can’t, and shouldn’t, abandon equities completely, but you need an approach that you are comfortable with, so you will continue to invest methodically.