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Know the basics: Is a Roth right for you?
What is a Roth IRA?
A Roth IRA is a tax-advantaged individual retirement account. Unlike an employer-sponsored retirement plan like a 401(k), you can open and contribute to a Roth IRA on your own, at most banks and online brokers.
Why would you want to have a Roth IRA? Major perks of this kind of retirement account include tax-free investment growth and the ability to withdraw contributions at any time. You can contribute to a Roth IRA at any age, as long as you have earned income, and a Roth IRA does not require minimum distributions in retirement. You can use the account to pass money to heirs if you’d like, unlike a traditional IRA and a 401(k), which both have required minimum distributions beginning at age 70 ½).
There are two main kinds of IRAs: Roth IRAs and traditional IRAs. The difference lies in their tax treatment. You don’t get a tax deduction on contributions you make to a Roth, but those contributions and your investment earnings grow tax-free. That means there’s no income tax when you withdraw from a Roth IRA in retirement.
With a traditional IRA, you get a tax deduction on contributions you make now, in exchange for paying income taxes when you pull money out in retirement. That makes this comparison about whether you want to pay taxes now or later. For most people, the answer should be now: That allows you to lock in your current tax rate, earn investment growth tax-free and protect your account from unknown future tax changes.
If you’re offered a 401(k) at work and your employer matches your contributions, you should save for retirement in that account first. Once you’ve contributed enough to earn the full match, consider contributing to an IRA.
There is a Roth version of the 401(k), but it hasn’t been widely adopted by employers. If your company only offers a traditional 401(k), the benefit of also contributing to a Roth IRA is tax diversity in retirement: You’ll have one pot of after-tax dollars from the Roth IRA, and one pot of tax-deferred dollars in the traditional 401(k). That can allow you to control your taxable income.
Because of the huge tax benefits of a Roth IRA, there are a fair number of rules. But the Roth IRA is flexible about one thing: early distributions. In fact, you can remove your contributions to the account at any time without penalty. If you want to remove earnings, however, you may be taxed or penalized unless the distribution is what the IRS considers qualified.
The other important rule regards the amount you can contribute: up to $5,500 in 2017, or $6,500 if you’re 50 or older. If your adjusted gross income is over $186,000 as a joint filer or $118,000 as a single filer, the amount you can contribute to a Roth IRA is reduced. Once your AGI tops $196,000 (joint) or $133,000 (single), you’re not eligible to contribute to a Roth IRA at all.
Most online brokers, banks and robo-advisors offer Roth IRA accounts. 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.
HAVE AN OLD 401(K)? YOU CAN ROLL IT OVER INTO AN IRA
If you’ve left a job and the 401(k) that came with it, you can roll that balance into an IRA. There’s one catch — if you have a traditional 401(k) and you choose to roll it into a Roth IRA, you’ll have to pay taxes on the amount rolled over, since the Roth IRA accepts only after-tax money. However, you’ll then be able to pull the money out tax-free in retirement.
If that kind of tax bill sounds out of reach, you can roll your balance into a traditional IRA. If you have a Roth 401(k), you won’t pay taxes to roll your balance into a Roth IRA, since that money was already contributed after taxes.
Once you’ve started funding your Roth IRA, you’ll want to invest those contributions. We recommend selecting a few index funds or ETFs, which are a low-cost method of diversifying across many different investments. Index funds and ETFs replicate an index. For example, a Standard & Poor’s 500 index fund invests in 500 of the largest companies in the United States. As an investor in that fund, you’ll hold small pieces of those companies.