The Roth IRA is a retirement account that offers valuable tax benefits, but it comes with eligibility requirements. It's a particularly valuable vehicle for those who anticipate high tax rates down the road.
The Roth IRA is the golden child of the retirement planning world. Investors, financial advisors and online brokers have been singing the praises of this individual retirement account since it was introduced in 1997, and for good reason: It is one of the most effective ways to save for retirement today.
What is a Roth IRA?
A Roth IRA is a tax-advantaged individual retirement account. Your contributions are made after tax, which means there’s no initial tax benefit. But that money and your investment earnings grow tax-free, meaning there’s no income tax on Roth IRA withdrawals in retirement.
There’s a common misconception that a Roth IRA is in itself an investment. It isn’t. Instead, it’s an account that holds your investments. You open a Roth IRA at a brokerage, then select from its investment options, which will include individual stocks, bonds, mutual funds and, in some cases, more aggressive investment strategies like options.
What are the benefits of a Roth IRA?
The Roth IRA has a lot of high points:
- It allows for contributions of up to $5,500 per year, and you can use it in addition to a 401(k).
- Investors 50 and older get to contribute an extra $1,000 a year as a catch-up contribution.
- The account is not subject to the sorts of minimum distributions typically required from a traditional IRA and a 401(k) beginning at age 70½. This means you can use a Roth to pass on money to your heirs.
- You’re contributing after-tax dollars, so you lock in taxes paid at your current tax rate, not the rate you’ll be at when you retire. If you expect your tax rate to go up, either because of across-the-board legislative increases or because you’re at the beginning of your career, this could be a large savings. It makes Roth IRAs especially attractive to younger workers.
- Because you’ve already paid taxes on your Roth contributions, you can withdraw them without tax or penalty before you retire. You may, however, be taxed or penalized if you withdraw your investment earnings.
- You can use Roth IRA money to pay for qualified college expenses without an early distribution penalty, so you can use the account to supplement or as an alternative to a college savings account like a 529 plan. There are no limitations on how you can use contributions, but distributions of earnings may be taxed.
Once you hit 59½ and you’ve held the account for at least five years, you can take distributions, including earnings, from a Roth IRA without paying federal taxes. This is the biggest difference between the Roth and traditional IRA: The traditional IRA nets you a tax deduction on contributions for the year you make them, but distributions are taxed in retirement.
Are you eligible for a Roth IRA?
Here’s the one downer: Because of their tax superiority, Roths aren’t available to high earners.
In 2017, Roth IRA income limits mean the amount you can contribute begins to dwindle at $118,000 in income for single filers and $186,000 for those married filing jointly. The contribution limit then slowly phases down until your ability to contribute is eliminated completely.
One note for high earners, however: A backdoor Roth IRA strategy, which involves converting a traditional IRA into a Roth IRA, may allow you to sidestep these income limits.
» In the phase-out range? Our Roth IRA calculator works out your reduced contribution limit.
Where can you open a Roth IRA?
Most online brokers, banks and robo-advisors offer Roth IRAs. You’ll want to look for a provider that has low account fees, a large selection of no-transaction-fee mutual funds and commission-free exchange-traded funds, and strong customer service. You should also consider the IRA provider’s account minimum, though most companies keep this reasonable considering the overall contribution limit of $5,500 per year.
Choosing the right provider for you
A good first step in the Roth IRA shopping process is deciding whether you want to take a hands-off approach to investing — in which case a robo-advisor and its automated investment process might be appealing — or a more active approach to choosing your investments, which might make a traditional broker more attractive.
NerdWallet’s highest-ranked providers for hands-off Roth IRA management are Wealthfront and Betterment. Robo-advisors employ computer algorithms to offer investment plans tailored to your goals and time horizon, all for a fraction of the cost of traditional investment advisors, and the companies below are two of the pioneers and leaders in this space today.
Two of NerdWallet’s top picks for conventional Roth IRA brokerages are TD Ameritrade and E-Trade. These brokers appear in NerdWallet’s rankings because of their low costs, large mutual fund selections and no account minimums.
» Want the deep dive? See our comprehensive analysis of the Best Roth IRA account providers.