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.
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.
|Filing status||2017 modified AGI||Maximum contribution|
|Married filing jointly or qualifying widow(er)||Less than $186,000||$5,500 ($6,500 if 50 or older)|
|$186,000 to $195,999||Contribution is reduced|
|$196,000 or more||Not eligible|
|Single, head of household or married filling separately (if you did NOT live with spouse during year)||Less than $118,000||$5,500 ($6,500 if 50 or older)|
|$118,000 to $132,999||Contribution is reduced|
|$133,000 or more||Not eligible|
|Married filing separately (if you lived with spouse at any time during year)||Less than $10,000||Contribution is reduced|
|$10,000 or more||Not eligible|
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.
How do 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.
» See our recommendations: Best Roth IRA account providers
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, 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.
» Find out more about rollovers: See our quick guide to 401(k) rollovers
How should you invest your IRA?
A Roth IRA is an investment account; once it’s open and funded, you’ll need to select investments. Use your age and risk tolerance as a guide, as both help indicate how you should allocate your money between stocks and bonds.
With a longer time horizon until retirement, you’ll want to tilt your portfolio heavily toward stocks. If retirement is approaching quickly, you may want to select a larger bond allocation, though you still want to include stocks in your portfolio for growth. You want your money to last not just to retirement, but through retirement.
You can buy both stocks and bonds through index funds and exchange-traded funds, two low-cost investment options that track a segment of the market. You can buy a Standard & Poor’s 500 index fund, for instance, and instantly hold a piece of 500 of the largest companies in the United States. Index funds let you diversify immediately for little money and time.
» Read more about: How to invest your IRA
» Save on taxes today: Use NerdWallet’s free retirement planning tool to see which investing accounts give you the most tax benefits.
Updated April 25, 2017.