A Roth IRA Can Supercharge Your Retirement Savings. Here’s How to Open One

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Roth IRAs have become a popular retirement savings tool thanks to their flexibility and tax advantages. Investors love them because they help shield you from taxes..

About one third of IRA investors use a Roth, according to data from the Investment Company Institute, a global association which regulates funds. Investing early and often is the secret to a wealthy retirement.

So what exactly is a Roth IRA? We’ll cover that in this article, along with the requirements to use a Roth IRA, how it differs from other retirement accounts, and whether it’s the right choice for you.

What Is a Roth IRA?

A Roth IRA is an individual retirement account that offers tax advantages. You put money in, invest it, and pull the money out when you retire. 

Understanding Roth IRAs

Money contributed to a Roth IRA is always after-tax dollars, meaning the money you get after you pay all your taxes goes into a Roth. This is different from a 401(k), where you put pre-tax money into the account.

Pro Tip

The key to deciding whether a Roth IRA is right for you is determining whether you expect your tax rate to be higher or lower during retirement. Roth IRAs are especially effective for people to expect their tax rate to increase during retirement since it allows them to pay the taxes now and enjoy tax savings later on.

Once you contribute money to your Roth IRA, you invest the money and it grows tax-free in your account. Then when you reach a 59 ½,  you can take distributions from your Roth IRA without paying taxes on your contributions or earnings.

Roth IRAs are different from employer-sponsored retirement accounts, and many people often use them to supplement an existing 401(k) plan. By having both accounts, investors are taking advantage of both tax benefits

What Can You Contribute to a Roth IRA?

The IRS sets limits on the amount that investors can contribute to their Roth IRAs each year. In 2022, the maximum amount you can contribute to a Roth IRA is $6,000 or your taxable income for the year, and in 2023, you can deposit $6,500, whichever is lower. For example, if you only earned $5,000 this year, then your contributions would be limited to $5,000 rather than the normal $6,000 limit.

The IRS also allows a catch-up contribution for those age 50 or older. In 2022, investors age 50 or older can contribute an additional $1,000 per year, bringing their maximum contribution to $7,000.

Who’s Eligible for a Roth IRA?

A Roth IRA can be a powerful financial tool to help you prepare for retirement in a tax-advantaged way. But because of income limits in place, this tool isn’t available to everyone.

To contribute up to the maximum allowed in an IRA, your Modified Adjusted Gross Income (MAGI) must be under $144,000 for tax year 2022, and $214,000 if you’re married or filing jointly. There is a completely legitimate way to get around these income limits called a backdoor Roth IRA, which entails converting a traditional IRA into a Roth IRA.

Many workers may eventually see their income increase to the point where they can’t contribute later in their careers. For that reason, Roth IRAs are a great option for people at the beginning of their investing journey. 

“We do see a lot of early-career employees who opt for the Roth because they hope their salary grows,” said Lazetta Rainey Braxton, a certified financial planner and the co-founder of the financial planning firm 2050 Wealth Partners. “And this is the best time when they’re just getting started and going ahead and paying taxes while they’re in a lower tax bracket because their salary is lower.”

The Spousal Roth IRA

The IRS requires that someone have taxable income to contribute to a Roth IRA that year, which could place non-working spouses such as stay-at-home parents at a serious disadvantage. Luckily, the IRS has a process in place for those individuals to still prepare for retirement.

A spousal IRA allows anyone to contribute to an IRA based on their spouse’s taxable income, even if they didn’t have any taxable income of their own. For example, if one spouse worked outside the home while the other stayed home to care for the children, both spouses could contribute up to the $6,000 maximum (or $7,000 for those age 50+) in a given year in 2022.

While both spouses can contribute up to the maximum each year, their combined contributions can’t exceed the total household taxable income.

Opening a Roth IRA

Opening a Roth IRA can be done in just a few minutes. While these accounts have some unique features, opening one is similar to opening any other type of brokerage account.

Step 1: Make Sure You’re Eligible

Before opening a Roth IRA, be sure that your income falls under the limits set by the IRS. While you may technically still be able to open an account if your income is too high, you won’t be allowed to contribute. 

Step 2: Choose Which Broker to Use

There are plenty of brokers to choose from when you’re opening your Roth IRA. Some of the best online brokers include Vanguard, Fidelity, and Charles Schwab.

When you’re choosing a broker, consider factors such as the fees the company charges to open or maintain your account, what types of investments are available, and what customer support the company offers.

Step 3: Complete the Application

Once you’ve chosen a broker, there will be a short online form you’ll have to complete. You’ll have to share information such as your name and contact information, Social Security number, identification number, and employer.

Step 4: Fund Your Account

The next step to opening your Roth IRA is to fund your account. You can make a lump-sum contribution to your account or set up an automatic contribution by connecting your IRA account to your bank account.

For each tax year, you have until tax day of the following year to make your Roth IRA contributions. For example, you can contribute to your Roth IRA for the 2022 tax year up until tax day 2023.

Step 5: Choose Your Investments

The Roth IRA is an investment vehicle, but it’s not an investment in and of itself. Once you open your account and deposit money, you’ll also have to choose which investments you want your money to go toward.

Most brokers will offer you a wide variety of investments to choose from. Pooled investments such as mutual funds, index funds, and exchange-traded funds (ETFs) are popular choices because they make it easy to invest in many securities at once. It also helps spread out your investments among many securities, rather than just one. Similarly, a target-date fund is a diversified portfolio fund that adjusts its holdings as you near retirement. 

And investors that want to be entirely hands-off with their investments can choose a robo-advisor. Some major brokers offer robo-advisory services as one of their offerings, while other companies specifically operate as robo-advisors.

Withdrawals: Qualified Distributions

A Roth IRA is a tool designed to help you save for retirement. Because of that, there are restrictions around when you can take qualified distributions (meaning tax-free and penalty-free withdrawals). 

In general, you may only take qualified distributions from your Roth IRA once you’ve had the account for at least five years and you reach age 59½. That being said, there are plenty of exceptions to this rule. For example, you may take qualified distributions if you are disabled. And when you die, a distribution can be made to your beneficiary or your estate.

Other situations where you may withdraw money from your Roth IRA after five years without paying taxes or a penalty include:

  • To buy, build, or rebuild your first home
  • To pay for unreimbursed medical expenses that are more than 7.5% of your adjusted gross income
  • To pay for medical insurance premiums while unemployed
  • To pay for qualified higher education expenses

Finally, Roth IRAs are unique because you’ve already paid taxes on your contributions. As a result, the IRA allows you to withdraw your contributions — but not your earnings — at any time. For these reasons, some financial planners say that Roth IRAs make great backup emergency savings accounts. 

Of course, just because the IRS allows you to withdraw your contributions doesn’t necessarily mean it’s a good idea. The money you put into the account is meant to prepare you for retirement. When you withdraw your contributions, that money is no longer growing and compounding. So for each dollar you withdraw, you’re reducing the amount you’ll have available during retirement by many times more. The name of the game in investing is long-term — keep your money in as long as possible so compound interest can work its magic.

Required Minimum Distributions

Certain retirement accounts require that you start taking required minimum distributions from your account starting at age 72. This rule doesn’t apply to Roth IRAs, meaning there’s no requirement that you withdraw money at all. For that reason, a Roth IRA may be used to pay for your later retirement years or as a way to pass on money to the next generation.

Withdrawals: Non-Qualified Distributions

The Roth IRA provides a surprising amount of flexibility when it comes to withdrawals. As we discussed above, there are several exceptions in place that allow you to take distributions before reaching 59½ as long as you’re withdrawing only your contributions or using your withdrawals for certain purposes.

That being said, if your withdrawal doesn’t meet the IRS requirements for a qualified distribution, then it will be considered non-qualified. In that case, the portion of your distribution that is earnings may be subject to taxes, as well as an additional 10% penalty.

Roth IRA vs. Traditional IRA

The Roth IRA has become one of the most popular investment vehicles for retirement savings thanks to its flexibility. Another tool available is the traditional IRA. Like a Roth IRA, a traditional IRA is an individual account rather than an employer-sponsored one.

When you contribute to a traditional IRA, you’re able to deduct your contributions, which reduces your taxable income in the year you make the contribution. The money in the account grows tax-deferred, and you’ll pay income taxes on the distributions you take during retirement.

“Ultimately, the question of opening a Roth IRA centers around a pivotal question – do I think my income tax rate in retirement will be lower or higher than it is right now?” says Eric Thompson, a Certified Financial Planner and wealth advisor at Round Table Wealth Management.

In general, a Roth IRA is more suitable if you expect your tax rate to be higher during retirement since that’s when it allows you to enjoy the tax savings. A traditional IRA might be the right choice if you expect your retiree tax rate to be lower.

Are Roth IRAs Insured?

One of the greatest concerns that many people have with putting their money into an investment account is whether it will be safe. The fact is that anytime you invest, you take on the risk you could lose money if your investments perform poorly.

There are still some protections in place to protect you against certain losses.

First, the Federal Deposit Insurance Corporation (FDIC) insurance protects the money in Roth IRAs and other IRAs at FDIC-insured banks. Your money is protected up to $250,000 per depositor per account type.

If your IRA is housed at a brokerage firm instead of a bank, then your money is protected by the Securities Investor Protection Corporation, which insures up to $500,000 of cash and securities.

It’s important to note that the FDIC and SIPC are designed to protect account holders from financial loss if a financial institution fails and can’t return its customers’ money. These agencies don’t protect investors from loss when their investments underperform.